Mortgage insurance allows homebuyers to purchase homes with down payments of less than 20%.
This credit improvement tool requires you to pay an additional fee with your mortgage to protect the lender from financial loss if your home is foreclosed on.
Given how difficult it can be to save for a large down payment, mortgage insurance is often the key to purchasing a home. However, buyers who are considering purchasing a home that would require mortgage insurance should carefully consider whether the additional monthly cost is worth it.
Summary
Mortgage insurance explained
Mortgage insurance is a type of insurance that protects lenders in the event of a borrower defaulting on their mortgage loan. It is typically required for home buyers who make a down payment of less than 20% of the total price of the home.
The monthly cost of insurance is typically a percentage of the loan amount, which is added to the borrower’s monthly mortgage payment. Insurance payment may vary based on:
- Type of loan
- Amount of the deposit
- Creditworthiness of the borrower
Typically, once you reach 20% equity in your home, you no longer need to pay mortgage insurance. At that point, you should request your lender to remove it.
Why do you need mortgage insurance?
If you want to buy a property but don’t want to, or can’t, spend 20% on a down payment, you probably need mortgage insurance.
Mortgage insurance is almost always required for conventional home loans when the buyer’s down payment is less than 20% of the home price. Some lenders have policies that allow borrowers to make a down payment of less than 20% without the need for mortgage insurance. However, these “no-SME loans” usually come with higher interest rates.
So, if you don’t have the money to make a large down payment, then you will need mortgage insurance to have the ability to still purchase the home you want.
Government-backed loan programs, such as Federal Housing Administration (FHA) loans, also have mortgage insurance requirements, each with a unique set of rules.
What are the types of mortgage insurance?
There are two main types of mortgage insurance: Private Mortgage Insurance (PMI) and Mortgage Insurance Premium (MIP).
Private Mortgage Insurance (PMI)
Private financial institutions can require PMI for homebuyers who cannot make at least a 20% down payment. The cost of PMI is typically added to your monthly mortgage payment and can range from 0.3% to 1.5% per year of your loan amount. The exact cost of PMI will depend on a number of factors, including your credit score.
You can eventually cancel your PMI once you’ve built up enough equity in your home. This typically happens when you have paid off the loan enough to reach a loan-to-value ratio of 80% or less. If the value of your home increases, this may also help you reach the equity threshold sooner, but an appraisal would likely be necessary.
Most PMIs fall under what’s called borrower-paid mortgage insurance (BPMI), which, as the name suggests, means it’s the borrower’s responsibility to cover the fees. Typically, this PMI is paid monthly, but you may also have the option to pay a one-time premium for mortgage insurance. This is the so-called single premium mortgage insurance.
There’s also lender-paid mortgage insurance, where a lender covers your insurance costs but in exchange you’ll have a higher mortgage rate, so your monthly expenses are even higher than they would be without insurance.
Mortgage Insurance Premium (MIP)
The MIP is required for FHA loans. These loans are government-insured and are designed to help first-time homebuyers and those with lower incomes purchase homes.
The cost of MIP is generally added to your monthly mortgage payment. In 2023, the annual fee has been lowered to 0.55% of the loan amount (for most eligible borrowers). Unlike PMI, which you can cancel when you reach a certain level of equity in your home, MIP is usually required for the life of the loan. This means you will have to pay the MIP until you pay off the loan or refinance into a different type of loan.
(If you’re thinking about refinancing, read our guide to the best mortgage refinancing options and follow a checklist of steps for refinancing your mortgage.)
In addition to your monthly MIP payments, you may have a one-time charge called upfront MIP. This payment is typically 1.75% of the loan amount, and you have the option to fund it into your loan.
Similar fees on other government-backed loans
There are two fees associated with other government-backed loans – the USDA guarantee fee and the VA financing fee – that function almost like mortgage insurance.
USDA Guaranteed Commission
The U.S. Department of Agriculture (USDA) guarantee fee is required for home buyers looking to purchase a home in a rural area with a USDA loan. This type of loan is backed by the USDA and is designed to help low- and moderate-income homebuyers.
The USDA upfront guarantee fee is 1% of the loan amount and there is an annual fee of 0.35%.
While not technically insurance, the guarantee fee is often lumped into the same category because it works in a similar way. Lenders use this fee to offset the costs associated with providing the loan and to ensure the long-term sustainability of the USDA loan program. The fee can be paid upfront at closing, or it can be financed with the loan.
VA Financing Fee
The VA financing fee is required for home buyers who wish to purchase a home with a loan guaranteed by the Department of Veterans Affairs (VA). This type of mortgage is available to veterans, active duty service members, and spouses of service members — active or veteran. These loans also do not require a down payment, making them a more affordable option for veterans and service members.
The VA financing fee can range from 0.5% to 3.3% of the loan amount.
Like the USDA Guaranty Fee, the VA Financing Fee is also not technically insurance.
Benefits of Mortgage Insurance
Although it is an additional expense, mortgage insurance has several benefits if you are looking to purchase a home.
Low down payment: The biggest benefit of mortgage insurance is that it allows you to purchase a home with a low down payment. For conventional loans, a 20% down payment is generally required. Considering the current real estate market, this down payment can be quite significant. But with mortgage insurance, you could put down as little as 3% and still get the home you want.
Cancellation: You can usually cancel mortgage insurance once you have built up enough equity. This means that the higher monthly payments are only temporary.
Cons of Mortgage Insurance
Like any financial product, mortgage insurance also has its disadvantages.
Additional cost: The main disadvantage of mortgage insurance is the cost. The cost of mortgage insurance is typically added to your monthly mortgage payment and can range from 0.3% to 1.5% per year of your loan amount. For some people, this additional cost can represent a significant long-term burden. Be sure to weigh the pros and cons to see if waiting longer to save for a typical down payment makes sense for you or if it’s better to potentially pay a few hundred dollars more each month.
Some types of mortgage insurance (or similar fees) cannot be canceled: If you’re counting on being able to cancel your mortgage insurance once you’ve built up equity, keep in mind that this usually only applies to private mortgage insurance on conventional loans. Most insurance and similar fees for government-backed mortgages apply to the entire life of the loan, regardless of equity.
6 steps to take to prepare for mortgage insurance
If you’re looking to buy a home without committing to a large down payment, you need to know how to efficiently manage mortgage insurance. Here are the next steps to take.
1. Understand the types of mortgage loans and insurance
Know the differences between the types of mortgage insurance described in this guide to know which option applies to your home purchase. Research different loans offered by both private institutions and the government to find the one that best suits your needs.
2. Check your credit score
Before you can apply for a low down payment loan, you’ll need to review your credit score. If possible, try to improve your credit score as much as possible before applying for a home loan.
3. Decide on a lender
Not all lenders offer the same mortgage insurance rates and terms. Compare rates and terms from different lenders to find the best mortgage lender for you.
4. Understand the terms and conditions
Read and understand the terms and conditions of your mortgage insurance policy. This will help you understand when and how you can cancel your insurance and what the penalties are for early cancellation.
5. Budget accordingly
Work the cost of mortgage insurance into your monthly budget. This will help you figure out what you can afford and make sure you don’t go overboard.
6. Keep an eye on your capital
If you’re planning on canceling your mortgage insurance, keep an eye on your equity. As soon as you have enough equity in your home, you may be able to cancel your insurance and save money on your monthly mortgage payment.
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