What is Mortgage Insurance?
Funding a down payment can be one of the biggest obstacles to homeownership as well as when refinancing a property. Loans typically require a borrower to make a down payment for the property they are considering, which could represent a significant expense, especially when added up with the other out-of-pocket costs new homeowners must budget for, such as closing costs, home insurance, and so on. However, mortgage lenders may be willing to consider an application with a lower down payment if the borrowers have a good credit score and some home loans are available for low or no down payments.
There is a caveat for these low down payment options. Since borrowers do not have as much skin in the game, mortgage lenders often require that they purchase mortgage insurance to secure a home loan.
Unlike home insurance, which protects your property and belongings in case of liability or adverse events, private mortgage insurance protects the lender if the borrowers were to default on their mortgage payments. The borrower is still at risk of losing the property to foreclosure if they do not meet their mortgage obligations. Although this option allows homebuyers to reduce their upfront costs when buying a house thanks to a smaller down payment, purchasing private mortgage insurance will affect their monthly payments until they have enough equity in the property and, in turn, how much house they can buy.
Here is everything you need to know about mortgage insurance.
When is Private Mortgage Insurance Needed?
Most mortgage lenders require borrowers to purchase private mortgage insurance (also known as PMI) when they are contracting a new conventional mortgage if their down payment is less than 20% of the purchase price or if they are seeking to refinance their home with a loan-to-value ratio of less than 80% of the property market value. The borrowers have little control over their private mortgage insurance provider. In most cases, the lender arranges PMI directly with their provider of choice.
Government-backed home loans, such as an FHA loan, allow borrowers to access homeownership with a down payment as low as 3.5% of the purchase price. However, these home loans require mortgage insurance with the mortgage insurance premiums to be paid directly to HUD/FHA. Mortgage insurance on FHA loans is paid in 2 parts; Upfront mortgage insurance premiums, referred to as UFMIP, is most often financed into the loan amount. In addition, a monthly mortgage insurance premium is paid with the monthly mortgage payment.
Types of Mortgage Insurance
There are different types of mortgage insurance.
Borrower-Paid Mortgage Insurance
In most cases, your mortgage insurance premiums will be part of your monthly bill, which also includes your principal and interest payments and other costs, such as property taxes and hazard insurance. If you want to lower your monthly payments and have enough money on hand, you may also choose to pay your mortgage insurance premium in a single lump sum at closing. Although it will lower your monthly bill compared to what you would have to pay with a monthly premium, and you will not need to refinance your mortgage to eliminate PMI once you have enough equity, beware that no portion of the single premium is refundable if you choose to refinance or sell the property before you have enough equity in the property to eliminate PMI.
Lender-Paid Mortgage Insurance
On rarer occasions, your mortgage lender will pay your PMI. However, the borrower is not off the hook and will need to repay their mortgage insurance premium in the form of higher interest rates or a higher mortgage origination fee. Although it represents a lower cost upfront, you will repay your lender over the life of the loan, and lender-paid PMI is not refundable. Like borrower-paid mortgage insurance, lender-paid mortgage insurance can only be removed from the loan by refinancing the loan or selling the property. However, one of the main advantages of this type of mortgage insurance is that, in some cases, the monthly payment could still be lower than making monthly PMI payments despite the increased interest rates.
How Much is Mortgage Insurance?
The cost of mortgage insurance varies based on your loan amount, loan-to-value ratio, and credit score. Typically, the average cost of mortgage insurance ranges between 0.22% and 2.25% of your mortgage. According to Freddie Mac, most borrowers pay between $30 and $70 per month for MIP for every $100,000 borrowed. Mortgage lenders typically choose the lowest cost mortgage insurance provider for their borrowers.
What Factors Impact Private Mortgage Insurance?
Several factors affect PMI:
- The size of your home loan: The more you borrow, the larger your mortgage insurance premiums will be. This amount varies depending on the purchase price of the property and the size of your down payment — if you pay more in the down payment, you will pay less in PMI.
- Your credit score: Your credit score signals to the mortgage lender whether you are more or less likely to meet your mortgage obligations. Borrowers with higher credit scores (760 and above) typically have lower PMI rates.
- The type of mortgage you are contracting: Fixed-rate mortgages usually have lower mortgage insurance premiums than adjustable-rate mortgages since the latter are perceived as riskier for the mortgage provider.
How to Stop Paying Mortgage Insurance?
Private mortgage insurance protects the mortgage lender until the borrower has enough skin in the game (a.k.a. enough equity in the house) and is less likely to default.
There are several options to stop paying PMI once your mortgage principal balance is less than 80% of the original appraised value or the current market value of your home, whichever is less, depending on your lender and the type of home loan you have contracted. Some mortgage lenders automatically drop the MIP once you are scheduled to reach the 78% LTV point. In other cases, you may need to contact your mortgage provider once you have at least 20% equity in the property. You may also need to refinance your mortgage in order to drop the PMI. In most cases, the mortgage lender will request a home valuation – either an appraisal or a BPO (“Broker Price Opinion” is a professional opinion of value) – before accepting to cancel your mortgage insurance requirements.