What is Mortgage Insurance and Why Does it Matter?
What is Mortgage Insurance?
Mortgage insurance helps both borrowers and lenders. It protects lenders against financial loss if homes go into default, reducing the amount of risk they take when they fund loans. And mortgage insurance helps borrowers buy homes with smaller down payments. Mortgage insurance is offered by a few government agencies as well private parties. Each has their own guidelines.
Mortgage insurance is typically required when the loan-to-value (LTV) of the property is less than 80%. This the industry standard; 80 LTV is what lenders consider a reasonable margin of safety. Very simply:
- LTV higher than 80% = borrowers must carry it
- LTV lower than 80% = borrowers are not required to carry it
Who pays for mortgage insurance? Borrowers.
Some mortgage programs require a one-time, upfront fee paid at the time of closing. Upfront fees typically run 1 to 2 percent of the total loan amount. In some cases, upfront fees can be rolled into the principal balance.
Some loan programs have an annual, ongoing insurance premium that is divided up and paid monthly. It’s a small fee that is added to the overall mortgage payment, along with the principal, interest, taxes and homeowner’s insurance.
Depending upon the mortgage program, both upfront and annual premiums may be required (more on this below).
Why Does Mortgage Insurance Exist?
Why not just make everyone put at least 20% down when they buy a home?
First, a 20% down payment is a lot of money. On a $300,000 starter home, a 20% down payment comes to $60,000. That’s a rather large sum of money, especially given the typical income of a buyer shopping in the $300,000 price range.
Second, just because people can’t come up with a 20% down payment doesn’t mean they are a high-risk borrower. In fact, most folks who can’t put together a large down payment turn out to be excellent burrowers, paying their monthly mortgage payment like clockwork.
Lenders have a lot of historical data at their fingertips and do a reasonably good job predicting foreclosure rates. Risk modeling for mortgages is not much different than doing so for car insurance. We know only a small percentage of drivers will get in a wreck this year. And we know only a small percentage of homeowners will default. This fundamental to insurance: when a large number of people contribute to an insurance pool, risk is spread out. Thus, more people can buy a home without the burden of a massive down payment.
What are the Benefits of Mortgage Insurance?
The general concept of mortgage insurance helps borrowers and lenders several fronts. It creates a low-friction path to home ownership. That’s good for parties on both sides of the transaction.
Lower Down Payments
A few government agencies, along with the private sector, run insurance pools. This means there are quite a few low down payment options, depending upon the borrower profile.
- FHA loans serve low and moderate income borrowers for as little as 3.5% down
- VA loans help veterans and servicemembers buy homes for 0% down
- USDA loans help low and moderate income borrows – in rural areas – buy a home for 0% down
- Conventional loan programs are available that require as little as 3.0% down
Buy a Home Sooner
It doesn’t take as long for borrowers to save enough money for a down payment when the when a smaller amount is required. Obviously, it’s faster and easier to reach 3% of a home’s value than 20% of a home’s value.
Increased Purchasing Power
Smaller down payments also help borrowers get more for their money. Say you’ve saved up $15,000 to buy a home. Here’s how that amount is represented as a down payment percentage:
- 3.0% of a $500,000 home
- 3.5% of a $428,571 home
- 20.0% of a $75,000 home
Mortgage insurance helps lenders reduce their risk. They are less likely to lose money on foreclosed properties. In aggregate, across many lenders, mortgage insurance creates economic stability.
Increased Lending Power
Risk reduction lends itself (pun intended) to more forgiving underwriting standards (lower down payments, less-than-perfect borrower credit, and so on). That means more homes get financed and more customers are served.
Types of Mortgage Insurance
Upfront and Annual Premiums
Upfront and annual mortgage insurance premiums can be configured separately or used together depending upon the rules of any given mortgage program. Here’s how the major mortgage programs use them:
- Upfront Mortgage Insurance Premium (UFMIP) is paid at closing
- Annual Mortgage Insurance Premium (MIP) is paid as part of the monthly mortgage payment
If your FHA loan opened prior to June 3, 2013, MIP goes away automatically when LTV reaches 78%. For FHA loans closed after June 3, 2013 – and where the LTV has reached 80% – it must be refinanced and replaced with a conventional mortgage in order to get rid of the annual mortgage insurance premium.
- VA Guarantee Fee is paid at closing
- No annual mortgage insurance is required
- Upfront Guarantee Fee is paid at closing
- Annual Fee is paid monthly for life of the loan
- No upfront mortgage insurance premium
- Private Mortgage Insurance (PMI) is paid as part of the monthly mortgage payment
PMI goes way automatically when the loan-to-value (LTV) reaches 78%. Borrowers may refinance the loan to cancel PMI when their home’s LTV reaches 80%.
Mortgage Insurance FAQs
What is FHA mortgage insurance?
What does mortgage insurance cover?
Insurance protects lenders against losses if borrowers are unable to repay a loan. Specifically, lenders will get back the principal balance of the loan.
What is VA mortgage insurance?
This is an insurance pool run by a government agency, in this case, the Veteran’s Administration. VA backs 25% of the amount of a loan made by private lenders. Borrowers must meet certain requirements, not the least of which is honorable military service.
What is a Mortgage Insurance Premium (MIP)?
This is either a one-time upfront fee or monthly charge that is paid by the borrower. Premiums contribute to a broader insurance pool that covers financial losses in the case of loan defaults.
What is Upfront Mortgage Insurance Premium (UFMIP)?
This type of mortgage insurance is paid all-at-once when the home loan closes. It goes by different names, such as:
- Upfront Mortgage Insurance Premium (UFMIP) – this is the FHA version
- Funding Fee – this is the name used for VA and USDA loans
What is annual mortgage insurance?
This is the version of MI that is paid on an ongoing basis. The annual premium is divided up so that borrowers pay 1/12th of it each month.
How do I get rid of mortgage insurance?
When folks say they want to get rid of mortgage insurance, they’re talking about the annual premium. The process for canceling it depends on the type of mortgage you have.
- Conventional loans have a built-in mechanism that makes PMI go away automatically
- Older FHA loans have a built-in cancellation policy and newer FHA loans carry mortgage insurance for life; the only way to cancel it is to refinance into a conventional mortgage
- USDA loans carry mortgage insurance for life and must be refinanced into a conventional loan to remove it
- VA loans do not have ongoing, annual mortgage insurance premiums
How much does mortgage insurance cost?
- UPMIP (FHA) and Funding Fees (VA, USDA) run around 1% to 3% of the loan amount
- Annual mortgage insurance premiums run around 1%
- Some mortgage program tier the percentage of the premium based on the loan-to-value (LTV)
What is private mortgage insurance (PMI)?
Private Mortgage Insurance (PMI) is just like it sounds, it’s a private version of mortgage insurance that functions a lot like the government agency pools run by VA, FHA, etc.
What is lender-paid mortgage insurance (LPMI)?
For conventional loans, some lenders will pay the mortgage insurance for the borrower at the loan closing. However, lender-paid mortgage insurance is not free; it is offset by charging the borrower a slightly higher interest rate on the mortgage.