What Is Mortgage Insurance & Do I Need It?
Article • 11/23/2021 • 10 minute read
What Is Mortgage Insurance & Do I Need It?
Insurance is a necessary component of many large purchases. Car insurance, for instance, helps to protect you financially in the event of certain damage to your vehicle. And health insurance can prevent high costs upfront if you ever need to get a procedure completed.
Your home is no exception, and there are multiple different forms of insurance that you’ll need to protect yourself from potentially devastating financial losses. One of these is mortgage insurance.
The thing about mortgage insurance is that it doesn’t protect you -- it protects the lender. But it’s sometimes an unavoidable expense when purchasing a new property. Here’s everything you need to know about this fundamental component of the homebuying process.
What Is Mortgage Insurance?
Mortgage insurance is a type of protection for the lender to lower the risk when they give you a home loan. If you happen to fall behind on your payments, mortgage insurance ensures that the lender is financially protected in order to recoup any losses.
With that said, it doesn’t offer you the same privileges. In fact, you’ll still suffer from a lower credit score if you miss your payments, and you may even lose your home due to foreclosure despite having paid for mortgage insurance.
Is Mortgage Insurance Required?
When you purchase a home, you’ll likely need to make an upfront down payment towards the total cost of the property. Most lenders like to see a down payment of at least 20% of the home’s total price, as this acts as a bit of a safety net in case you ever get behind on your payments.
Of course, that’s out of the question for many individuals, and lenders understand that not everyone can make a 20% down payment. With that in mind, most mortgage companies will require private mortgage insurance (PMI) to act as a sort of protection if you default on the loan.
If you take out a conventional home mortgage, which typically has more attractive features compared to alternatives, you’ll likely need to pay PMI. Additionally, it tends to be required if you refinance your home and your equity is less than 20% of your home’s value.
Mortgage Insurance vs. Homeowner’s Insurance
Mortgage insurance often gets confused with homeowner’s insurance, but they are extremely different from one another. Mortgage insurance protects the lender, not you if you default or struggle to make monthly payments.
Homeowner’s insurance protects you in case your property becomes damaged by an external force.
How Does Mortgage Insurance Work?
Even though you need to pay for private mortgage insurance, it doesn’t offer you any protection. Mortgage insurance pays the lender a portion of your principal balance if you ever fall behind on, or fail to make, any of your payments.
You’ll pay PMI as a PMI premium each month, rather than just a single upfront fee. The cost of PMI varies based on the size of your home loan, your credit score, the amount of money you still owe on the home, and many other factors.
Factors Affecting the Cost of Mortgage Insurance
The cost of your PMI varies based on several factors, so you need to talk to your lender about specifics. However, the following and influential in determining your end-cost:
- Fixed or adjustable-rate interest
- Loan term
- Down payment or loan-to-value ratio
- Credit score
- The premium plan chosen
- Amount of the mortgage coverage required by the lender
In general, the “riskier” you appear on paper, the higher your premiums will be. This is because lenders want to have comfort knowing that they will not lose any money by offering you a home loan.
Cancelling Mortgage Insurance
The good news about private mortgage insurance is that you don’t need to keep paying it forever. You can ask to cancel your PMI after you have over 20% equity in your home. Additionally, you must have a good payment history, and you may need to provide evidence to your lender that the value of the property has not declined.
Additionally, your lender will automatically terminate your PMI once you reach 22% equity in your home, even if you don’t file a formal request for termination.
Finally, even if you haven’t reached 22% equity in your home by the time you reach the midpoint of your loan amortization schedule, your lender is required to waive PMI. This is one month after the half-point of your loan’s full term.
How to Avoid Paying Mortgage Insurance
Sometimes, paying mortgage insurance is necessary if you don’t have the upfront cash necessary to make a 20% down payment. However, it can save you some money in the long run if you’re able to avoid making monthly premium payments.
The first and most obvious way to avoid paying PMI is to make the 20% down payment. You can try to do this by enhancing your savings or putting money aside specifically for making a home down payment.
Another option that proves to be popular and successful for avoiding PMI is something called a piggyback mortgage. There are many variations of this type of home loan, though the 80/10/10 model is most common.
Piggyback mortgages are actually two home loans put together. One main mortgage covers 80% of your home’s total cost, while you’ll take out another home mortgage loan at 10% of the value.
That equals a total of 90% of the total value of your home, meaning that you only need to make a 10% down payment upfront. But since your second “piggyback” mortgage covers the other 10%, you can hit 20% down and avoid paying mortgage insurance.
This can significantly lower your monthly payments, even though you’ll still be responsible for paying interest on your second home loan.
The main drawbacks of piggyback loans are that they tend to be difficult to qualify for, as you need to qualify for two home loans rather than just one. With that said, they are a great option if you can only afford 10% down but want to avoid monthly PMI premiums.
Types of Mortgage Insurance
You’ll want to be familiar with a few different types of mortgage insurance, as you may have some agency over which one works with your given situation.
Borrower-Paid Mortgage Insurance
This is the most common type of mortgage insurance, and it occurs when the loan borrower pays monthly premiums to protect the lender. You’ll continue paying your premiums until you hit 22% home equity, at which point the lender automatically cancels it. Or, you can request cancellation once you reach 20%.
Some lenders allow borrowers to cancel PMI sooner based on something called value appreciation. For instance, if you’ve only accumulated 23% home equity due to the value of your home rising, despite only paying for 19% of the home’s original value, a lender may consider allowing you to stop paying PMI.
Lender-Paid Mortgage Insurance
While this form of PMI may seem like the lender is technically paying for your mortgage insurance, don’t be fooled. You’ll actually still pay it yourself in the form of slightly higher interest rates each month.
Since it’s built into the loan terms, you can’t cancel this form of PMI once you reach 22% equity. The only way to get rid of it is through refinancing.
With that said, monthly payments tend to be lower with this form of PMI than the premiums you’d need to pay with borrower-paid mortgage insurance.
Single-Premium Mortgage Insurance
With this form of PMI, you’ll make a single lump-sum payment right up front when you close on your home, rather than monthly installments. What’s good about this is you don’t need to worry about refinancing out of PMI, and your monthly payments will be lower since you don’t need to spend as much on premiums.
The downside is that no portion of this type of mortgage insurance is refundable if you decide to refinance. Not to mention, if you can’t make a 20% down payment upfront, you probably can’t afford to make an upfront payment in the form of single-premium mortgage insurance, either.
Split Premium Mortgage Insurance
This form of PMI is very uncommon, and it’s basically a hybrid between borrower-paid and single-premium mortgage insurance.
First, you’ll pay a part of the mortgage as a lump sum at closing and then part of it monthly. So you don’t need to pay as much down at closing, and you also don’t need to pay as much monthly.
This is a good idea if you have a high debt-to-income ratio. However, this is an option that most lenders do not offer.
FHA Loan Mortgage Insurance
Federal Housing Administration (FHA) loans are great options for people who may not be eligible or meet the criteria for conventional mortgages. They’re also great for first-time homebuyers, as you don’t need as high of a down payment. However, PMI works a bit differently here.
Unlike conventional mortgages, everyone must pay an upfront premium when taking out PMI with an FHA mortgage. The major catch is that this premium does nothing to lower your monthly payments in the same way that single-premium mortgage insurance does.
So with an FHA loan, not only will you need to pay an upfront mortgage premium, but you will also still need to pay monthly premiums. This can be extremely costly.
The only reason to do this is if your credit score is too low to qualify for a conventional mortgage. If you can make at least 10% down on your home, it’s typically wise to look at other options, such as a piggyback mortgage.
Are Mortgage Insurance and Mortgage Protection Insurance the Same Thing?
PMI exists solely for the lender’s protection and nothing else. However, mortgage protection insurance (MPI) is a type of credit life insurance that pays off your mortgage balance after you die. The remaining balance goes to a bank or mortgage lender, which differs from a typical life insurance policy.
MPI can help protect your family members from facing foreclosure on the property after you’ve passed, but it also gives them no say in how the remaining equity is spent. This power lies in the hands of the bank or the lender that the protection insurance is paid to.
Mortgage insurance is a fee that many homeowners need to pay, but it doesn’t actually offer the buyer any protection. Instead, it serves as a safety net for the lender if you cannot make payments on your mortgage.
Most lenders will require mortgage insurance if you cannot make at least a 20% down payment on the home’s total value. With that said, you can avoid it with a piggyback mortgage or by trying to get lender-paid mortgage insurance.
Dealing with multiple lenders and mortgage companies in your home buying process can make your head spin. At Network Capital, we make it easy by doing everything in-house, under one roof. And on top of that, we’re fast, getting you to the closing table in as little as 15 business days.
Let us help you live better.
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