To avoid excess risk, mortgage lenders are willing to finance homes with 20% down. The reasoning is that if a buyer defaults and a home must be sold at foreclosure, it's still likely that the lender's money will be completely recovered if the buyer paid 20% up-front.

But most first-time home buyers don't have 20% to put down. The solution is to allow buyers to purchase a home with less money down, and one way to do that is to make a trade: less cash up front in exchange for a guarantee to lenders from a strong third party. This is the concept behind VA and FHA financing where borrowers can purchase with little or nothing down: If there's a default the government will compensate the lender for much or all of the loss.

But while the VA mortgage program is excellent, not everyone has the service experience necessary to participate. And while the FHA program has historically helped many entry-level buyers, in recent years the program has been beset by high insurance costs, excessive appraisal requirements, and loan size limitations. So what's a would-be borrower to do when they don't have 20% to put down on their new home?

The solution is private mortgage insurance (PMI) and it works like this: buy now, put down what you can afford, and use PMI to offset the hefty down payment.

There are various PMI plans and they typically work like this:

• The more you put down, the less coverage you need. In other words, more insurance is required with 5% down, less insurance with 15% up-front.
• Adjustable-rate mortgages, ARMs, are perceived as more risky than fixed-rate loans, thus PMI costs are somewhat higher.
• The borrower pays for PMI coverage, but if the loan is defaulted, the lender is the policy beneficiary.
• It is possible for a lender to conditionally approve a loan, and also for a PMI company to decline coverage.

There are costs for PMI coverage since it is insurance and these costs amount to monthly premiums based on the amount of outstanding debt.

How long do you need PMI?
The HomeOwners Protection Act of 1998 (HPA) was legislation that covers mortgages originated after July 29, 1999 for the purchase, initial construction, or refinancing of a borrower's one-family principal residence. It provides that if the borrower has a good payment history, then once the original debt has been reduced 22%, PMI must be canceled.

The rules also allow borrowers to request PMI cancellation after they have reduced their loans 20 percent. However, in addition the guidelines also permit lenders to retain PMI coverage for 15 years in the case of so-called 'high risk' loans. The good news is that PMI is cancelled after 15 years for all loans.

The new rules relate the cancellation of PMI to a reduction of the original loan amount -- not the difference between the current loan balance and the property's present value. This means if you borrow $100,000 at 8 percent interest over 30 years, you'll pay $733.76 a month for principal and interest. The loan balance will not dip below $78,000 until 14 years and six months later. By then, most likely, you will have sold or refinanced the home.

Fannie Mae and Freddie Mac buy loans from local lenders. Their rules establish standard practices for lenders nationwide, and when it comes to canceling PMI both have adopted guidelines which are well within the realm of reason. Fannie Mae and Freddie Mac say this: If you have a loan they own, if you have a good payment history, if the loan-to-value ratio of your home is not greater than 80 percent, and if you ask, then there is a good case to cancel PMI coverage.

Both Fannie Mae and Freddie Mac consider how much you owe versus the property's value, not just a reduction in the loan balance. This means you may have owned a home for five years, paid down relatively little on the mortgage (because home loans are interest-heavy up front), but seen home values rise. Between your original down payment, amortization, and rising property values you now have 20 percent equity. With good credit you may well be able to cancel PMI.

How do Fannie Mae and Freddie Mac know what your home is worth? They don't. This means you must be able to show that your home has a given value. The way this is done is by having an appraiser approved by your lender value the property.

What's an 'acceptable payment record?' Freddie Mac says borrowers must have no late payments for the past two years. What's a 'late payment?' A payment at least 30 days overdue. For Fannie Mae, good credit means no payments 30 days late for at least one year and no payments 60 days late for two years.

Implicit in these rules is a period for loans to 'season.' This means if your home suddenly shoots up in value three days after you move in, you should still expect to continue PMI payments. Under Fannie Mae's rules, for instance, a loan must season five years if a cancellation is sought with 20 percent equity, but only two years for 25 percent equity.

The cancellation request rules for both Fannie Mae and Freddie Mac apply to loans made before July 29, 1999. This means there are cancellation opportunities for millions of homeowners.

To get PMI canceled early, you must take the initiative and contact the lender who collects your payments. Ask who owns your loan. If not Fannie Mae or Freddie Mac, check the policies of the loan holder. Many are also updating PMI cancellation standards.