When you take out insurance—health, home, life, auto—it’s for your own protection against unexpected circumstances, setbacks, and expenses. When buying a home, it’s sometimes the lender who wants coverage in the form of mortgage insurance. What is mortgage insurance and when do you need to buy it?
What is mortgage insurance?
Mortgage insurance is a policy that provides coverage to the lender in the event the borrower doesn’t make the loan payments. The homeowner may default on the loan or pass away with a balance due. The terms and payments for mortgage insurance vary according to the type of loan you’re taking and how much of a down payment you make. Depending on the mortgage insurance plan you choose, you’ll have other criteria that affect your cost.
Do I need mortgage insurance?
Mortgage insurance may be a requirement of loan approval, not optional as with other types of insurance policies. It is typically required of homebuyers who are providing less than 20 percent of the purchase price as a down payment. With less of a financial investment in the home you’re buying—and less equity—the lender wants assurances that you’re committed to adhering to the payment terms of the loan. The lender considers this type of loan to be a higher risk than with borrowers who have a more significant down payment. This risk comes at a price. And in this instance, you’ll be paying the price of an insurance premium.
Types of private mortgage insurance
There are two primary types of mortgage insurance: private mortgage insurance (PMI) and mortgage and mortgage insurance premium (MIP).
A PMI is usually required on a conventional loan when you’re financing more than 80 percent of the loan total. As you pay down your loan through monthly payments, you gain equity in your home, which is calculated as loan-to-value (LTV) ratio. This measurement compares the amount of your loan with the market value of the home. If you put down 10 percent on the purchase of your home, your LTV is 90 percent. The lower the LTV, the more equity you have in your home.
When you’ve achieved 20 percent LTV, you can request that your lender cancel the PMI. Don’t expect it to automatically fall off your mortgage statement. In some cases, a lender might proactively cancel the PMI when you’ve reached a 22 percent equity level (a 78 percent LTV). Check with your lender to determine their specific requirements at the outset of your loan. For example, you might need to pay for a home appraisal in order to prove the home’s value.
Four types of PMIs
Borrower-paid monthly (BPMI)
BPMI is the most common type of private mortgage insurance and the one that lenders typically refer to as just “PMI”. The premium is calculated prior to closing on the purchase of your home, and the monthly premium is included with your mortgage payment. You don’t pay it separately.
Single premium
You can opt to pay the full amount of your private mortgage insurance in one lump sum at closing. The amount will be determined by the loan amount and your credit score.
Split premiums
The split premium private mortgage insurance plan is a combination of the BPMI and single premium. At closing, you pay part of the total cost of the PMI and then the balance is distributed in your monthly payments.
Lender-paid (LPMI)
In spite of the name, the lender is not paying your private mortgage insurance premium. Instead, they offset the cost by increasing your interest rate. You should compare the cost of the additional interest with the cost of your monthly BPMI in order to determine the best choice.
Like many insurance plans, you have a variety of policies. Here are the types of mortgage insurance and what distinguishes each one.
Mortgage insurance premium
A mortgage insurance premium (MIP) is required of all Federal Housing Authority (FHA) loans. These government-insured loans help buyers with as little as 3.5 percent down payment and a credit score as low as 580 to purchase a home at a low interest rate. These loans require the borrower to pay an upfront fee at closing, equal to 1.75 percent of the amount being borrowed. Then, the homebuyer also pays a monthly premium that is included with the mortgage payment.
What’s the difference between PMI and MIP?
A PMI and MIP are not the same. A PMI, as explained above, is required when less than 20 percent is paid as a down payment. When the homeowner achieves 20 percent equity in the home, they can request the private mortgage insurance to be canceled.
With an MIP, which is solely used with an FHA home loan, the premium remains for the full term of the loan. It cannot be terminated, even when the equity reaches 20 percent or more. However, the homeowner can refinance the loan to a non-FHA loan program.
Do I need a PMI for a zero-down payment mortgage?
The Veterans Administration (VA) and US Department of Agriculture (USDA) offer government-insured home loans that finance the entire amount of the home purchase. No down payment is required for qualified borrowers.
Does that mean you need to pay for private mortgage insurance?
No. Neither the VA home loan nor the USDA home loan requires you to pay a PMI. Instead, the buyer must pay a fee. The USDA calls it a “guarantee fee” of 1 percent of the loan amount at closing and an annual fee of 0.35 percent, which is distributed into monthly payments. The VA calls the cost a “funding fee”, calculated at 0.5 to 3.6 percent of the loan amount, depending on the loan and the borrower’s service status. The funding fee for a VA home loan can be paid at closing or incorporated into the mortgage.
How much does mortgage insurance cost?
The cost of private mortgage insurance varies. The premium will be calculated according to several factors:
- Credit score
- Interest rate (fixed or variable)
- Loan term (e.g., 10, 15 or 30 years)
- Down payment amount
- Debt-to-income ratio
- The state where you live
PMI rates range, on average, between 0.2 and 2 percent of your total loan amount per year. If you’re borrowing $300,000 and your lender gives you 0.5 percent as the PMI cost, you’ll be paying $1,500 per year, or $125 a month.
Can I cancel mortgage insurance?
You may be able to cancel your PMI when you reach 22 percent equity in your home, or 78 percent loan-to-value ratio. Talk to your lender before you commit to the PMI program to understand your options for eliminating the premium.
You cannot cancel the MIP on an FHA loan. To get rid of the premium, you’ll have to refinance the home loan to one that is not managed by the FHA.
Can I avoid private mortgage insurance?
The most direct way to avoid the cost of private mortgage insurance is to come up with a 20 percent down payment. Talk to a lender to discuss the cost of a PMI with the down payment you have. Then you can determine whether it’s beneficial to pay the PMI or wait until you can save up more to put down on the purchase of the new home.
Another option is down payment assistance programs. State housing finance agencies may offer a grant or low-interest loan to assist with your down payment, usually limited to first-time homebuyers.
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