If you buy a home and put less than 20% down, chances are you’ll pay mortgage insurance to get approved for a mortgage. This insurance protects lenders in high-risk situations, such as when borrowers don’t make a large down payment.
Here’s everything you need to know about mortgage insurance and how it works.
Mortgage insurance is an insurance policy for lenders, but borrowers pay the premiums. It’s a level of protection against default. For example, if a borrower stops making his/her payments, the mortgage insurance will cover the financial loss.
How Does Mortgage Insurance Work?
Mortgage insurance covers the lender, even though borrowers pay for it. The only time a lender needs to file a claim on the mortgage insurance is if you default on your loan and they have to initiate foreclosure.
There are a few different types of mortgage insurance, each of which works differently.
Private Mortgage Insurance
This is the mortgage insurance you’ll pay on a conventional loan if you put down less than 20% on the home. Borrowers pay PMI until they owe less than 80% of the home’s value. If you pay your PMI monthly, you can request cancellation when you have 20% equity in the home.
There are a few ways to pay PMI:
Lump sum – You can pay the entire PMI premium upfront. This works best for borrowers who have long-term plans for the home because you don’t get a refund of the insurance if you move early.
Monthly – You can spread the premium payments out until you’re scheduled to owe less than 80% of the home’s value. Then, if you pay the balance down faster or the home appreciates faster, you can request early cancelation.
Split premium – You can pay part of the PMI premium upfront and spread the rest out over your monthly payments.
Lender-paid – Your lender can pay the PMI premiums in one lump sum, but you’ll pay a higher interest rate in exchange.
Mortgage Insurance Premium
FHA mortgage insurance is called MIP. The FHA charges two types of insurance – upfront MIP and annual MIP. Upfront, you’ll pay 1.75% of the loan amount, and annually you’ll pay 0.85% of the outstanding loan balance.
The annual mortgage insurance premium decreases annually as it’s based on your mortgage balance. So the more you pay it down, the less insurance you’ll owe.
Unlike PMI, borrowers can’t cancel PMI. Instead, you’ll pay it for the life of the loan. So the only way to eliminate MIP is to refinance into a conventional loan when you owe less than 80% of the home’s value.
VA Funding Fee
The VA funding fee is a form of mortgage insurance on VA loans. However, the VA doesn’t charge annual mortgage insurance; they only charge an upfront funding fee of 2.3% of the loan amount.
USDA Guarantee Fee
If you borrow a USDA loan, you’ll pay a guarantee fee upfront and annually. The upfront fee is 1% of the loan amount, and the annual fee is 0.35% of the outstanding loan amount. Like FHA loans, borrowers pay the USDA guarantee fee for the life of the loan.
The Benefits of Mortgage Insurance
You might think mortgage insurance is a nuisance or makes buying a house harder, but the opposite is true.
Mortgage insurance protects the lender, which allows them to have more flexible guidelines. For example, most lenders would require a 20% or higher down payment without PMI. This would make it much harder for borrowers to secure financing because, with PMI, you can put down as little as 3% - 5% on a home.
How to Get Rid of Mortgage Insurance
The good news is that you don’t have to pay mortgage insurance forever. It may require a little work, but you can eventually cancel it.
Request Cancellation of PMI
PMI is the easiest insurance to cancel. You can request cancellation when you owe less than 80% of the home’s original value. You may also request early cancellation by paying for a new appraisal if the home appreciated faster and/or you paid the loan down faster. However, this is up to lender approval and is on a case-by-case basis.
Lenders must cancel the insurance automatically if you don’t request cancellation when you owe 78% or less of the home’s original value.
Refinance your Loan
If you have an FHA or USDA loan and want to cancel your mortgage insurance, you must refinance the loan into a conventional loan. This is best done when you owe less than 80% of the home’s value because you can avoid PMI too.
Avoiding Mortgage Insurance
If you want to avoid mortgage insurance, you will need a 20% or higher down payment. If you don’t have enough to put down, you can use financial gifts from family members.
You can apply for a piggyback loan if that's not an option. This is a second mortgage that ‘piggybacks’ on your first mortgage. For example, your first mortgage would provide 80% of the home’s price, the second mortgage would provide 10%, and you provide the final 10%. This would avoid PMI and allow you to buy a home with only 10% down.
Mortgage insurance is helpful when you want to buy a house but don’t have a large down payment. It’s the lender’s reassurance that they won’t lose a lot of money lending to you without a large down payment.
There are ways to get around mortgage insurance and cancel it once you own the home. The key is to make sure you buy a home with a mortgage you can afford and that you make your payments regularly so you can cancel mortgage insurance when you owe less than 80% of the home’s value.