In a perfect world, all homebuyers would have the cash to pay at least 20 percent down on their home purchases. In the real world, it can be tough to scrape together a fraction of that amount, especially for the 59 percent of buyers who draw from savings to make their down payments. Mortgage insurance makes it possible for these would-be homeowners to buy a home with little or no money down.
What Is Mortgage Insurance?
Homebuyers who make small or no down payments — and therefore have little or no equity in their homes — have higher default rates than buyers who put more money down. Mortgage insurance makes it safer for lenders to loan money to these higher-risk borrowers by covering the lender’s losses in the event a buyer defaults on their loan.
Unlike homeowner’s insurance, which you’ll shop around for and purchase on your own, the lender chooses the mortgage insurance company you use, said Joe Talmadge, vice president of mortgage lending for Northwest Federal Credit Union in Herndon, Va.
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Who Needs Mortgage Insurance?
You’ll be required to pay mortgage insurance if your financing falls into any of the following categories:
- Conventional mortgage loan for more than 80 percent of the value of your home
- Federal Housing Administration loan
- Department of Veterans’ Affairs loan
- U.S. Department of Agriculture loan
Depending on your loan type, the mortgage insurance premium might be paid up front, be included in the mortgage payment or be a combination of both.
How Much Is Mortgage Insurance?
Mortgage insurance premiums consist of a percentage of the principal amount owed on your loan. The percentage you pay depends on the type of mortgage insurance you need.
Private Mortgage Insurance: Up to 1.5% of Your Loan Amount
Private mortgage insurance, or PMI, is for conventional mortgage loans with a loan-to-value ratio of less than 80 percent — that is, the loan amount equals 80 percent or more of the home’s value.
The premium typically costs between 0.2 percent and 1.5 percent of your loan amount. You can pay the upfront premium with your closing costs or add it to your loan, and then pay the ongoing premium annually or in monthly installments, as part of your mortgage payment.
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FHA Mortgage Insurance Premium: 1.75% Up-Front, Plus Up to 1.05% of the Loan Amount, Monthly
When you finance a home with an FHA loan you pay a mortgage insurance premium, or MIP, to the U.S. Department of Housing and Urban Development. HUD insures FHA loans to protect lenders against losses from borrower defaults.
You’ll pay a 1.75 percent upfront MIP at closing and make monthly payments on an annual premium that ranges 0.45 percent to 1.05 percent of the loan amount, depending on your loan-to-value ratio and the length of the loan.
You can finance the upfront MIP by adding it to your mortgage loan.
VA Funding Fee: Up to 2.15%
Although VA-guaranteed loans don’t have mortgage insurance, notes Scott Hillegass, an Allentown, Pa. military mortgage specialist with the Fairway Independent Mortgage Corporation, the funding fee works in much the same way.
Regular military vets using their benefit for the first time pay a 1.25 percent, 1.50 percent or 2.15 percent funding fee for a loan with a down payment of 10 percent, 5 percent or $0, respectively. Rates for reservists and National Guardsmen are slightly higher.
Although the funding fee is charged up front, you can roll it into your mortgage loan.
USDA Guarantee Fee: 2.75% Up-Front Plus 0.50% Annually
USDA-guaranteed loans, which are designed to help low- and middle-income individuals in rural areas purchase safe, affordable housing, also have upfront and annual guarantee fees in place of mortgage insurance.
Although the 2.75 percent upfront fee is charged to the lender, the lender typically passes it on to the borrower. You can add the upfront fee to your mortgage loan and pay the .50 percent annual fee with your regular mortgage payments.
Mortgage Protection Insurance: Up to 1.5% of Your Loan Amount
Whereas mortgage insurance and guarantees protect the lender, mortgage protection insurance, or MPI, safeguards the borrower by temporarily paying your mortgage if you lose your job or become disabled. It will even pay off your loan if you die.
MPI is strictly voluntary, but it’s expensive. Expect annual premiums of about 0.50 percent of your loan amount for a bare-bones policy and up to 1.50 percent for more comprehensive coverage like living benefits that can offset the loss of income due to a catastrophic illness. Your premium stays the same whether your mortgage loan is brand new or almost paid off.
How to Avoid PMI and Other Mortgage Insurance and Guarantee Fees
Mortgage insurance is a necessary evil if you don’t have a 20 percent down payment. But that doesn’t mean you’ll be stuck paying high fees for the next 30 years.
In the case of a conventional loan, you can greatly reduce the cost by putting 10 percent or 15 percent down instead of the normal five percent, Hillegass said. And you can ask your lender to discontinue your PMI once you have 20 percent equity in your home. The lender will automatically discontinue it when you have 22 percent equity.
Remember that making your mortgage payment isn’t the only way to build equity. Increases in your home’s value add to it, too.
MIP premiums on FHA loans stop after 11 years if you purchase your home with 10 percent down or refinance with 10 percent equity. Otherwise, you’ll pay MIP for the life of the loan.
You’ll also pay guarantee fees for the life of a USDA or VA loan. But even then you have options. Refinancing into a conventional loan once you hit 20 percent equity will eliminate the guarantee fees. You’ll save even more if mortgage rates are lower when you refinance than when you took out your original loan.
Find Out: How to Get Rid of PMI
Alternatives to PMI
Buyers who negotiate and get creative with their financing sometimes find alternatives to paying PMI on their conventional loans. The following ideas won’t get you off the hook entirely, but they could save you money in the long run.
- Lender-Paid Mortgage Insurance: In some cases, the mortgage company pays for mortgage insurance in exchange for charging a higher interest rate.
- Single-Pay Mortgage Insurance: Some lenders allow you to pay off your whole mortgage insurance policy at closing without hiking your interest rate, reported Quicken Loans.
- Piggy-Back Mortgage: Also known as an 80-10-10 loan, this option results in a first mortgage to finance 80 percent of the home’s value, a second mortgage to finance 10 percent more and a down payment to cover the remaining 10 percent.
Mortgage Insurance Offers Unique Benefits
Mortgage insurance often feels like a necessary evil for homebuyers who get stuck paying it, but it offers unique benefits to some. In addition to possibly helping you qualify for a loan, holding onto your cash reserves can preserve your nest egg or serve as an emergency fund for unexpected home repairs. Even if the sole reason you’re not putting 20 percent down is that you simply don’t have the money, the gratification you get by investing in your own home instead of your landlord’s far outweighs the pain of paying the mortgage insurance premium.
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