What Is Mortgage Insurance and How Does It Work?
In a perfect world, all homebuyers would have the cash to pay at least 20% down on their home purchases. In the real world, it can be tough to scrape together a fraction of that amount. 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 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 homeowners 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, Virginia.
The coverage is also different. Whereas mortgage insurance protects the lender’s investment, homeowners insurance protects your investment by reimbursing you for damage to — or loss of — your home or belongings caused by a covered emergency.
Who Needs Mortgage Insurance?
You must pay mortgage insurance — or a comparable fee, in the case of a government-backed loan — if your financing falls into any of the following categories:
- Conventional mortgage loan for more than 80% of the value of your home
- Federal Housing Administration loan
- Department of Veterans Affairs loan
- U.S. Department of Agriculture loan
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 2.25% of Your Loan Amount
Private mortgage insurance, or PMI, is for conventional mortgage loans with a loan-to-value ratio of less than 80% — that is, the loan amount equals 80% or more of the home’s value.
The premium typically costs between 0.2% and 2.25% 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.
FHA Mortgage Insurance Premium: 1.75% Upfront, 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, instead of a PMI premium.
You’ll pay a 1.75% upfront MIP at closing or roll it into your loan, and make monthly payments on an annual premium that ranges from 0.45% to 1.05% of the loan amount, depending on your loan-to-value ratio and the length of the loan.
VA Funding Fee: Up To 3.5%
Although VA-guaranteed loans don’t have mortgage insurance, said Scott Hillegass, a military mortgage specialist with the Fairway Independent Mortgage Corp., the funding fee works in much the same way.
The fee ranges from 1.4% to 3.5% depending on the down payment and whether the vet or service member has used their guaranteed-mortgage benefit before. Although the fee is charged upfront, you can roll it into your mortgage loan.
USDA Guarantee Fee: Up To 3.5% Upfront Plus 0.50% Annually
USDA-guaranteed loans help low- and middle-income individuals in rural areas purchase safe, affordable housing. An upfront fee of up to 3.5% is charged to the lender, but the lender typically passes it on to the borrower. You can add the upfront fee to your mortgage loan and pay the 0.50% annual guarantee fee with your regular mortgage payments.
Mortgage Protection Insurance: Up To 2% 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% of your loan amount for a bare-bones policy and up to 2% for more comprehensive coverage like living benefits during 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
With a conventional loan, you can greatly reduce the cost by putting 10% to 15% down, Hillegass said. And you can ask your lender to discontinue your PMI once you have 20% equity in your home. The lender will automatically discontinue it when you have 22% equity.
Mortgage insurance premiums on FHA loans stop after 11 years if you purchase your home with 10% down or refinance with 10% equity. Otherwise, you’ll pay these premiums for the life of the loan.
You’ll also pay guarantee fees for the life of a USDA or VA loan. But you can eliminate guarantee fees by refinancing into a conventional loan once you hit 20% equity.
Good To Know
If you have a fixed-rate loan, your amortization schedule will show the date on which you’ll reach 20% equity.
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.
- Piggyback mortgage: Also known as an 80-10-10 loan, this is a first mortgage to finance 80% of the home’s value, a second mortgage to finance 10% more, plus your 10% down payment.
Mortgage Insurance Offers Unique Benefits
Mortgage insurance often feels like a necessary evil, but it offers unique benefits to some. In addition to possibly helping you qualify for a loan, holding on to your cash reserves can preserve your nest egg or serve as an emergency fund for unexpected home repairs.
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