What Is Mortgage Insurance? How It Works and Who Should Have It
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.
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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 and consumer 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 you have.
Conventional Loan
Private mortgage insurance: Up to 2.25% of your loan amount
Conventional loans are the standard loan type, and they’re structured to conform to Freddie Mac and Fannie Mae lending guidelines. Those guidelines state that borrowers with a loan-to-value ratio of more than 80% must pay for private mortgage insurance on their lender’s behalf.
The premium typically costs between 0.20% and 2.25% of your loan amount, with the first premium payment due at closing. You can pay that 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 Loan
Mortgage insurance premium: 1.75% upfront, plus up to 1.05% of the loan amount monthly
Whereas conventional loan mortgage insurance is called private mortgage insurance, mortgage insurance for FHA loans is called mortgage insurance premiums.
You can pay the 1.75% upfront premium at closing or roll it into your loan. Annual premiums range from 0.45% to 1.05% of the loan amount, depending on your loan-to-value ratio and the length of the loan. Borrowers typically pay the annual premium in monthly installments added in their mortgage payment.
The MIP on FHA loans automatically ends after 11 years, regardless of how much equity you have, if you made at least a 10% down payment when you purchased the home. Otherwise, you’ll pay the MIP for the life of the loan.
VA Loan
Funding fee: Up to 3.3% of the loan amount
VA loans are guaranteed by the VA, and they allow veterans and active-duty members of the military to buy a home with no money down.
These loans don’t have mortgage insurance, said Scott Hillegass, a military mortgage specialist with Fairway Independent Mortgage Corp. But they do have a funding fee that works in much the same way from the buyer’s point of view.
The fee for purchase loans and construction loans ranges from 1.25% to 3.3% of the loan amount, 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.
Some VA borrowers are exempt from paying the funding fee. If, for example, you receive or are eligible to receive VA compensation for a service-related disability, you’re on active duty and have received a Purple Heart, or you’re the surviving spouse of a veteran and are receiving Dependency and Indemnity Compensation, you won’t have to pay the fee. If you’ve already paid and later receive VA compensation for a service-related disability, the VA will refund your fee.
USDA Loan
Guarantee fee: Up to 0.65% of the loan amount upfront, plus 0.35% annually
USDA-guaranteed loans help low- and middle-income individuals in rural areas purchase safe, affordable housing. An upfront fee of up to 0.65% of the loan amount 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 0.35% annual guarantee fee with your regular mortgage payments.
Mortgage protection insurance, or MPI, is a type of credit life insurance that pays off your loan if you die. It’s strictly voluntary, but it’s expensive — 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, until your loan is paid off.
How To Get Rid of 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 a guarantee fee for the life of a USDA loan. But you can eliminate it and the FHA MIP by refinancing into a conventional loan once you hit 20% equity.
Remember that you build equity in several ways: by paying down your mortgage loan, through appreciating home values and by making improvements that increase your home’s value. If you suspect your home is worth significantly more than you paid, consider getting an appraisal — you might be able to get rid of your mortgage insurance or guarantee fee sooner than you thought.
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.
FAQ
Mortgage insurance adds a significant amount to the cost of financing a home purchase, so it's important to understand what it is and how it works before you purchase your home.
What does mortgage insurance do?
Mortgage insurance protects the lender against losses in the event the borrower defaults on their mortgage loan.
How do you pay mortgage insurance?
In most cases, you'll pay the upfront premium at closing, as part of your closing costs, and pay the annual premium in monthly installments included in your mortgage payment.
How much is PMI on a $300,000 mortgage?
That depends on the insurer and on your down payment amount, but expect to pay between 0.20% and 2.25%.
How long do I pay mortgage insurance?
You'll pay mortgage insurance until your loan-to-value ratio reaches 80% if you have a conventional loan. With an FHA loan, payments last for 11 years or the life of the loan, depending on your down payment amount.
Do you get mortgage insurance back?
No. As with other types of insurance, you pay a premium for protection during the term of the policy. Even if the lender didn't need to file a claim, it enjoyed lower risk during the coverage period, and based on that reduced risk, extended a loan with a lower down payment than it would otherwise have allowed.
Is mortgage insurance tax deductible?
No. It has been deductible in the past, but the deduction has expired.
This article originally appeared on GOBankingRates.com: What Is Mortgage Insurance? How It Works and Who Should Have It
