Lenders typically require home buyers to provide a down payment equivalent to 20% of the property’s purchase price to qualify for a loan. This amount, however, which can easily hit upwards to the tens to the hundreds of thousands of dollars, can be out of reach for many.
Enter mortgage insurance.
This type of coverage allows aspiring homeowners to get approved for a loan with as low as 3% down payment. The insurance helps you secure the loan with the backing of the insurance agency protecting the lender.
In this article, Insurance Business discusses how mortgage insurance works in different loan types, how premiums are calculated, and whether home buyers can avoid paying for this additional expense. This can also serve as a useful guide for those wanting to start their homeownership journey, so we encourage insurance agents and brokers reading this to share it with clients considering starting this journey.
While mortgage insurance enables home buyers who do not have sufficient funding for a traditional down payment to get loan approval, it does not cover them if they fail to meet monthly repayments.
Mortgage insurance is designed solely to protect the lender if the borrower defaults on their home loan.
By reducing a lender’s risk, this form of coverage also allows them to lend larger amounts and approve more home loan applications.
In order for homeowners to get protection should circumstances render them unable to pay out the remainder of their home loans, they need to purchase another type of policy called mortgage protection insurance (MPI).
Lenders typically arrange mortgage insurance on the borrowers’ behalf. And although such policies cover the lenders, it is the borrowers who shoulder the cost of premiums. There are generally two types of mortgage insurance. These are:
- Private mortgage insurance (PMI) for conventional mortgage
- Mortgage insurance premium (MIP) for federally backed home loans
Mortgage insurance works slightly differently depending on the type of loan. Here’s an overview of each.
Private mortgage insurance
Lenders impose PMI as a requirement for conventional loans where a borrower puts out a down payment of less than 20% of the home’s purchase price. This type of mortgage insurance may also be required if a borrower decides to refinance their mortgage and the equity built up is less than 20% of the property’s value.
PMI comes in four types based on how premiums are paid:
- Borrower-paid monthly: The most common type of PMI wherein the borrower pays monthly premiums as part of their mortgage
- Borrower-paid single premium: Borrowers make one upfront payment or roll the premiums into the mortgage
- Split premium: Borrowers pay a portion of premiums upfront and the remainder monthly
- Lender paid: Lenders initially shoulder the cost of the premium, which borrowers pay through higher interest or mortgage origination fees
Mortgage insurance premium
The premium structure for FHA-backed loans works similarly to that of split premium PMIs. Apart from a monthly MIP that borrowers are required to pay regardless of their down payment amount, they need to shell out an upfront mortgage insurance premium equivalent to 1.75% of the base loan amount.
VA home loans – designed for military veterans and their spouses – and USDA-backed mortgages – for buyers of rural homes – do not require mortgage insurance. Instead, borrowers of VA-backed loans pay a funding fee between 1.4% and 3.6% of the total mortgage, while DA mortgage holders pay an upfront fee equal to 1% of the loan amount and an annual fee of 0.35% of the total mortgage.
There are several factors that dictate the cost of mortgage insurance. For PMI, borrowers are expected to pay between 0.1% and 2% of their total home loans annually, depending on the following:
- The PMI type
- Whether the interest rate is fixed or adjustable
- The mortgage term or length of the home loan
- The loan-to-value (LTV) ratio
- The insurance coverage amount required by the lender
- The borrower’s credit score
- The property’s value
- Whether the premiums are refundable
- Additional risk factors determined by the lender
Lenders calculate the PMI premium rate, which is generally between 0.5% and 1% of the purchase price, based on these factors to determine a borrower’s risk level. Premiums are recalculated every year as the principal is paid off. This means that the amount the homeowner needs to pay in mortgage insurance is also reduced.
For example, a buyer who pays a 5% down payment for a $300,000 home will leave with a conventional mortgage totalling $285,000. If they are charged 1% PMI, they will need to pay $2,850 annually or $237.50 monthly, which can be incorporated into their regular repayments.
Lender-paid mortgage insurance, meanwhile, adds 0.25% to 0.5% to the interest rate. For FHA-backed home loans, yearly MIP payments typically range between 0.45% and 1.05% of the base loan amount.
Most PMI plans allow borrowers to cancel their policies once they have paid more than 20% of their total loan amount, so they do not need to continue paying for coverage for the entire mortgage term. Here are some other instances where borrowers can stop paying PMI:
- The property’s value rises building up 25% equity and the borrower has paid PMI for at least two years
- The property’s value rises building up 20% equity and the borrower has paid premiums for five years
- The borrower has put extra payments toward the loan principal to reach 20% equity faster than it would have through regular monthly repayments
Once any of the above scenarios happen, the borrower needs to file a formal request to waive PMI, so they can avoid paying unnecessary premiums. Lenders are also mandated by the law to automatically cancel mortgage insurance once equity reaches 22% as long as the borrower regularly meets monthly repayments.
Experts also advise borrowers to take a proactive approach and find out beforehand when they will reach the 20% benchmark, so they will know when their mortgage insurance payments will end.
MIPs, meanwhile, are removed after 11 years for those who have put down at least a 10% down payment. For borrowers with less than a 10% deposit, they are required to pay mortgage insurance for the full length of their home loan term.
Not anymore. Previously, homeowners were allowed to deduct mortgage insurance payments from their taxes. This arrangement, however, has expired after the 2021 tax year.
The most straightforward way to avoid paying for mortgage insurance is to put out at least a 20% down payment. This, however, does not apply to federally backed loans. For home buyers getting an FHA mortgage, there is no way around it. They are required to pay mortgage insurance premiums, regardless of how much deposit they are able to put down.
For conventional loans, if saving for a sufficient down payment is not an option, there are still several ways for borrowers to dodge this additional expense. These include:
First-time home buyer programs
Most states offer assistance programs in partnership with local lenders that allow first-time home buyers to take out low down payment mortgages with reduced or zero mortgage insurance requirements. Aspiring homeowners can contact their state’s housing authorities for more details about these programs.
Piggyback or 80-10-10 loans
In this arrangement, the borrower takes out two mortgages. The first covers 80% of the home’s purchase price while the second covers another 10% to 17%. They will then need to put out 3% to 10% down payment, thus the name 80-10-10. The second mortgage, however, often comes with a higher interest rate.
Piggyback loans are often marketed as a cheaper option, but it does not necessarily mean that they are. Experts still recommend that borrowers compare the total cost of this type of loan before making a final decision.
Military service members and members of the National Guard or reserves and their surviving spouses may qualify for a VA loan. This type of home loan allows a down payment as low as 0% and yet does not charge mortgage insurance.
While mortgage insurance can pave the way to faster homeownership, buyers also need to remember that it is an additional monthly cost that they need to allocate for.
This type of insurance may be worth paying for those who want to climb the homeownership ladder as soon as possible but do not have the time and resources to save for a 20% down payment. This is especially true in a property market where prices are rising faster than it allows aspiring homeowners to save or if there is a limited time for them to snap up their dream home at a good price.
For a review of it from the non-consumer end, read this article on essential insurances for mortgages to learn more about how this operates.
How about you? Do you have any experience in taking out mortgage insurance that you want to share? Chat us up in the comments box below.