Budgeting and planning for a new home can be harrowing tasks. In addition to finding a house that fits your lifestyle, you also have to budget for all the extras beyond the home’s price tag, including costs associated with closing and requirements imposed by your mortgage lender.
One of the most confusing of these — especially for those buying their first home — is mortgage insurance. If you’ve ever wondered what that extra charge is in your monthly mortgage payment, or if you’re curious about how to avoid it in the first place, read on.
What Is Mortgage Insurance and How Does It Work?
Mortgage insurance can be confusing because it doesn’t work the same way as the kinds of policies you might be used to. Whereas most insurance products are meant to protect you — the policyholder — through accidents or disasters that might arise, mortgage insurance protects the mortgage lender.
That’s right. Mortgage insurance exists to repay the bank in the event that you default on your loan.
That being the case, you might ask, “Why would anyone opt for it?” Well, in most circumstances for a conventional home loan with a down payment that is less than 20% of the purchase price, it’s required.
There are two main types: private mortgage insurance (PMI) and mortgage insurance premiums (MIP).
Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) is the most common because it’s required for most conventional home loans. When you purchase a home, it’s rare that you’d do so entirely with cash. Instead, you take out a mortgage for the purchase price, minus your down payment.
Based on those numbers, the broker will calculate the “loan-to-value ratio” by dividing the mortgage loan amount by the value of the property. If your loan-to-value ratio is over 80%, the broker will add a monthly fee to your mortgage payments to insure them in case of default.
In other words, unless your down payment is at least 20% of the total purchase price, you will be required to pay PMI until you’ve paid down your loan to the point where you owe less than 80% of your home’s value.
In fact, PMI can have a drastic effect on your monthly payment. Every year, PMI typically costs between 0.5% and 1% of your entire mortgage value, paid in monthly installments. That means that if you purchase a house valued at $200,000 and put nothing down, you’ll be paying up to $167 every month in PMI on top of your mortgage payments.
So it’s worth it to wait to buy a home until you’ve saved enough to make a substantial down payment. To continue the example above, if the purchase price is $200,000 and you put $40,000 down, your loan balance will be $160,000 and your loan-to-value ratio will be 80%. That’s great, because you won’t be on the hook for PMI.
But $40,000 is a big chunk of change, so PMI is a fact of life for many homebuyers. The good news: you won’t be stuck with it forever.
FHA Mortgage Insurance Premiums (MIP)
In reality, FHA premiums are very similar to PMI, just in a different package. FHA mortgages are covered not by private mortgage insurers but by the government’s Federal Housing Administration.
These loans have slightly different rules that allow people with lower credit scores to purchase houses with low down payments (as low as 3.5% — $7,000 for a $200,000 property) at lower interest rates.
Of course, those relaxed approval rules also mean a higher risk for the lender (in this case, the taxpayers), so FHA loans also come with the requirement for insurance, in the form of mortgage insurance premiums (MIP).
Besides the nature of the insurer, there are two major differences between MIP and PMI. First, the annual insurance rates for MIP are typically between 0.70% and 0.85% of the value of the loan. There is also an upfront lump sum payment included with MIP to the tune of 1.75% of the value of the home, which is rolled into the loan.
What does all that mean in real terms? If we take that $200,000 property as an example, with the lowest possible down payment of $7,000, how much would you be paying in mortgage insurance premiums? Your upfront lump sum would come out to $3,377.50, meaning your loan would start with a balance of $196,377.50 instead of $193,000.
When it came to your monthly payments, your monthly premiums could be between $122.53 (0.70%) and $143.53 (0.85%) on top of your mortgage payment.
What Are the Benefits of Mortgage Insurance?
With all that said, it might seem as though there is no upside to having mortgage insurance. There are, however, a few benefits to getting a loan backed by an insurance policy. These include:
Quicker approval rates. Unsurprisingly, if your loan is protected by an insurer, your lender will be taking on less risk. That means you can get your mortgage approved faster. This likely won’t affect FHA loans, however, since those are all insured and have to go through a more rigorous approval process.
Lower down payments. Coming up with a large down payment is one of the biggest barriers to homeownership, so mortgage insurance lets more people become homeowners. In truth, this is a mixed blessing. While being able to get a mortgage with a low down payment enables many people to buy a house, it can end up costing a lot more in the long run.
How Can I Get Rid of PMI or MIP?
Those are pretty weak as benefits go, so the next big thing to know about mortgage insurance is how to ditch it.
Getting Rid of PMI
Luckily, in most cases, PMI comes with a built-in expiration. Once you’ve paid down your loan to the point that your value-to-loan ratio is below 78%, PMI will automatically be canceled.
That said, if your value-to-loan ratio is below 80% but above 78%, you can also send a letter to your lender to request the cancellation of PMI. That could save you several months worth of mortgage insurance payments.
Remember how I said “most cases”? Always read the fine print in your mortgage documents. Some lenders require that you pay PMI for a set amount of time, even if you’ve paid your value-to-loan ratio down to 78%, and in those cases you’re stuck with it until the contract period expires.
Getting Rid of MIP
The biggest drawback to FHA loans is that MIP never expires. Even if you’ve paid a substantial balance on your mortgage, you’ll be required to pay your monthly insurance premium for the life of the loan.
That doesn’t mean you have no options, though. If you’ve reached the value-to-loan ratio of 78% with an FHA mortgage, you may be eligible to refinance to a conventional mortgage.
Use a Mortgage Calculator to Make Things Easier
All of this can be confusing for the first-time home buyer, I know. But don’t be dissuaded! There are a number of online tools that can help you calculate exactly what you can afford, with or without mortgage insurance. Try this tool, which has options for both FHA and conventional home loans.
Curtis Westman is a professional writer whose perilous journey through the process of buying real estate has been several years in the offing.