When people think of insurance, it’s typically as something they pay that protects their interests and assets. In the case of mortgage insurance, however, that’s not how it works. While the borrower on a mortgage pays for the insurance, it is the lender who is being protected.
It may seem backwards to pay for a lender’s insurance, but for many borrowers it’s the only option when buying a home. Often, you’ll hear of a homebuyer paying a 20% down payment, as doing so allows them to avoid paying mortgage insurance. However, seeing how roughly 70% of Americans are putting down less than 20% when buying a home, mortgage insurance is a lot more common than you think.
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While there are multiple factors that determine who pays mortgage insurance and at what rate, there are essentially two types to consider: private mortgage insurance (PMI) and mortgage insurance premium (MIP). As one applies to conventional loans and the other to FHA loan programs, there are several differences between the two.
Private Mortgage Insurance
For anyone taking out a conventional mortgage and putting down less than 20% for their down payment, PMI will be required by the lender. This is because PMI is based on risk, and the higher a mortgage’s loan-to-value (LTV) ratio, the higher the risk a lender is assuming. Furthermore, the lower the down payment amount, the higher the PMI rate will usually be.
Typically, PMI is baked into the monthly payment on a conventional mortgage at a rate that could range from under 1% to over 2% of the loan amount. The rate will be determined not only by the down payment amount, but by the loan term, borrower’s credit, and other contributing factors. Borrowers also have the option to pay the entire PMI upfront at closing (known as single-premium mortgage insurance), which is very uncommon considering the cost. A hybrid PMI model called split-premium mortgage insurance allows a borrower to pay some upfront and some on a monthly basis.
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There is also a type of PMI called lender-paid mortgage insurance (LPMI), in which the lender will pay your entire premium costs, but in return will charge a higher interest rate on the mortgage itself. There is a lot to consider with LPMI and if the increased interest rate is worth the money a borrower will save on not paying insurance.
While PMI is an added financial burden for those who have to pay it, it’s not a permanent cost for conventional loans. As a borrower continues to build equity with their monthly payments, to the point where their loan balance dips to 80% of the home’s value, they will be able to request a cancellation on their PMI. In fact, once the loan balance hits 78%, the lender is required to remove PMI from future loan payments.
Mortgage Insurance Premium
For FHA (Federal Housing Administration) loans, MIP is mandatory no matter what the down payment amount is. Since FHA mortgages allow down payments as low as 3.5%, there is a greater financial obligation as far as insurance, which is due both upfront (1.75% of the loan amount) and on an annual (paid monthly) basis (which varies depending on the mortgage terms). The upfront payment is rolled into the loan balance, but will only increase the monthly payment even further.
There are some loan terms where FHA cancels the Annual MIP after 11 years. For example, if a borrower pays at least a 10% down payment with a loan term greater than 15 years.. However, if a borrower pays less than 10% on their down payment, they are required to pay the MIP over the life of the loan.
As for the two other government loan programs, a USDA (US Department of Agriculture) mortgage works similarly to an FHA with both upfront and annual/monthly fees, which are known as Guarantee Fees. Meanwhile, VA (Veterans Affairs) mortgages only require a Funding Fee paid at closing, where applicable. All of the upfront requirements for the three government loan programs, can be financed into their respective loan balances.
While there is clearly a lot of nuance with mortgage insurance, the people who pay it all have one thing in common in the eyes of lenders (whether it’s a private company or government agency) — risk. The level of risk can vary, and for those who are able to build enough equity, mortgage insurance does not have to be a permanent cost of owning a home.
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