Final answer:
Private mortgage insurance on a conventional loan usually insures the top 20% of the loan. It is required when the down payment is less than 20% to protect the lender in case of default. The PMI insures a portion of the loan to reduce the lender's risk.
Step-by-step explanation:
Private mortgage insurance (PMI) on a conventional loan generally ensures the top 20% of the loan. This insurance is typically required when a home buyer puts down less than 20% of the home's purchase price as a down payment. Therefore, when you're able to put down less than this amount — say a 0-3.5% down payment — PMI ensures that the lender is protected in case you default on your mortgage payments.
As an example, if you purchase a $100,000 house and you put down 5%, which equals $5,000, you're borrowing $95,000 from the bank. In this scenario, the PMI would insure the top 20% of the $95,000, which amounts to $19,000, to safeguard the lender's interests.
Making a 20% down payment is often advised since it can result in lower monthly payments and the elimination of the need for PMI. However, saving enough to make this substantial down payment can be challenging, which is why there are options available for lower down payments, despite the additional cost of PMI that would be added to the mortgage over time.