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What Is Mortgage Insurance?

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Buying a home introduces you to a host of new terms, including words like "underwriter" and "mortgage rates." Another term you're going to hear is "mortgage insurance," and it's an important one to remember. That's because you could find yourself paying mortgage insurance for the life of your loan, depending on the type of mortgage you take on. Here, we'll tell you how mortgage insurance works and offer ways to avoid paying it.

What is mortgage insurance?

Mortgage insurance is an insurance policy which protects lenders. This insurance helps the lender recover their losses if a homeowner stops making payments. A borrower must pay for mortgage insurance if they put down less than 20% of the purchase price. In these situations, lenders worry about recouping their losses in the event of a foreclosure.

Lenders appreciate it when a home buyer makes a sizable down payment. A large down payment means the lender has less to lose. If the buyer defaults on a mortgage loan, the lender can repossess the home. Then, they sell the house at auction. If the borrower doesn't owe very much, the lender doesn't have to recover much money from the sale of the house. But if the borrower owes quite a bit, the lender has to try to sell the house for more money in order to cover their losses.

In the case of a conventional loan, mortgage insurance pays the lender the difference between the principal balance that remained when the home went into default and how much they are able to sell the property for. For example, if there was $300,000 remaining on the principal but the lender could only sell the property for $275,000, mortgage insurance would cover the $25,000 gap.

Each type of loan is handled in a slightly different way, but the goal is the same: To allow the lender to recover as much of a loan as possible following default.

What is private mortgage insurance (PMI)?

When you put down less than 20% on a conventional loan, the lender arranges for you to get mortgage insurance through a private third-party insurer -- hence the term "private mortgage insurance" (PMI). Use our simple mortgage calculator to figure out how much to put down to avoid PMI.

Here are four things to know about PMI:

  1. If your down payment is less than 20%, PMI is mandatory.
  2. There is little or no insurance premium due at closing.
  3. The annual premium is broken up into monthly payments.

It is possible to get rid of PMI once the loan balance falls below 80% of your home's value.

How does mortgage insurance work?

Once lenders learn you are putting less than 20% down on a mortgage, they factor in your need for mortgage insurance. While you're the one to pay for mortgage insurance, it's meant to protect the lender.

Lenders worry that buyers with less money invested are more likely to default on their mortgages. For example, if you buy a $200,000 home with 5% down, you would put down $10,000. That also means you would lose your $10,000 if you were to default. However, if you put 20% down, you'd be out at least $40,000 if you walked away from the home without paying off your loan. A large down payment gives a lender confidence that you're planning to pay off the entire loan.

Depending on the type of mortgage, your mortgage insurance premium may get tacked onto your closing cost, built into your monthly payment, or both.

How much does mortgage insurance cost?

The cost of mortgage insurance is a percentage of the money you borrow to finance your home purchase. The annual premium is typically between 0.5% and 1%.

Let's say you take out a loan for $250,000, but you don't put down 20%, so you must pay mortgage insurance. In this case, your mortgage insurance will cost between $1,250 and $2,500 annually, or between $104 and $208 monthly -- on top of the monthly payment for your loan.

Mortgage insurance and conventional loans

When you take out a conventional mortgage, the lender might arrange for you to purchase mortgage insurance through a third-party lender. That's why you sometimes hear mortgage insurance referred to as "private" mortgage insurance. The amount you pay is based on two primary issues: How much you put down and your credit score. This applies to conventional mortgage loans as well as other types.

Mortgage insurance and Federal Housing Administration (FHA) loans

There is a lot to like about FHA mortgages. Although FHA mortgage rates are typically a little higher than conventional loan rates, home buyers with lower credit scores have a better chance of qualifying. It's easier to get into an FHA mortgage with a low down payment, and most mortgage lenders have extensive experience dealing with FHA mortgages.

The downside is that a mortgage borrower must carry mortgage insurance and pay a monthly mortgage insurance premium (MIP), no matter how much is put down or how high the borrower's credit score. Another downside is that MIP cannot be easily dropped. If the loan origination date is June 3, 2013 or later, MIP will last the life of the loan, unless the borrower made at least a 10% down payment, causing the MIP to be canceled after 11 years. If the loan origination date is January 2001 to June 3, 2013, MIP will be canceled once the loan balance falls to 78% of the home’s value. If the loan origination is before January 2001, the borrower may not be able to cancel MIP at all, at least not without refinancing.

MIP is paid directly to FHA at closing, as well as through your monthly mortgage payments.

Mortgage insurance and U.S. Department of Agriculture (USDA) loans

U.S. Department of Agriculture (USDA) mortgages are part of a unique mortgage program offered to home buyers who wish to purchase rural properties. The program is designed to meet the needs of lower-income buyers, and includes maximum household income limits.

Although a USDA mortgage is similar to an FHA loan, the associated mortgage insurance is typically less expensive. If you opt for a USDA mortgage, you must pay an insurance premium at closing (or roll it into your mortgage, which raises the monthly payment) and pay a monthly mortgage premium.

Mortgage insurance and Department of Veterans Affairs (VA)-backed loans

A VA mortgage is designed for current and former members of the armed services, and their families. Rather than paying a monthly insurance premium, a borrower must pay an upfront funding fee. The fee varies based on how much you put down, if you are disabled, if you're purchasing a home or refinancing your existing home, and whether it's your first VA loan.

How to avoid mortgage insurance

If you cannot put 20% down on a loan, ask your lender about a "piggyback mortgage." If your credit score is high enough, you may be eligible for this unconventional way to avoid mortgage insurance payments.

A piggyback mortgage is sometimes called an "80-10-10" loan. It works like this: You put 10% down on a house, which leaves you with 90% to finance. You take out a mortgage for 80%, then a second mortgage for 10%. Since the first mortgage is only for 80%, it does not require a mortgage insurance premium. Second mortgages do not routinely require mortgage insurance, either. One advantage of this borrowing situation is that interest on both mortgages is typically tax deductible.

There are risks associated with piggyback mortgages. These risks include:

  • You have very little equity (ownership) in your home, which can be a problem if you need to sell.
  • It's easy to get in over your head with debt when you have two monthly mortgage payments.
  • Your debt-to-income (DTI) ratio is higher than it needs to be, and that can drag your credit score down.

If you're a veteran, your best bet may be a VA loan. Not only can you avoid mortgage insurance, but the lending standards are looser, meaning you don't need a high credit score to qualify.

Now that your question, "What is mortgage insurance?" is answered, you may decide to avoid it at all costs -- no matter which loan type best fits your situation. If so, take the time to save a 20% down payment. If your credit score is not quite where you want it to be, taking the time to save a larger down payment also offers you time to improve your credit score. The process may feel long and arduous -- but when you want to give up, just think of how good it will feel to know that you're buying a home with instant equity.

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