What is mortgage insurance and do you need it?

When you think of insurance, you typically think of something that protects you financially in the case of an emergency - like homeowners insurance does if something happens to your home. You might assume that mortgage insurance is another form of protection for your home, but it’s actually there to protect the lender.

So, what is Mortgage Insurance?

Mortgage insurance is something that banks or mortgage lenders use to protect themselves in case you default on your payments. If you take out a loan and are no longer able to pay, mortgage insurance will cover a portion of the loan to help alleviate any losses for the bank.

Lenders require private mortgage insurance (PMI) on a conventional loan when a borrower has less than a 20% down payment. Typically, lending to someone with a smaller down payment is considered more risky for the bank. If your down payment is 20% or more, the lender will not require it since they are at less of a risk.

Types of Mortgage Insurance

While PMI protects the lender, the cost falls on you, the borrower. This is the cost one pays in order to get financing they otherwise would not be able to. There are generally four types of mortgage insurance:

• Borrower paid mortgage insurance - This type of insurance is the most common. It is an additional cost added to your monthly mortgage payments. You make this additional payment until you own 20% of your home in equity. A good way to get out of paying PMI early in this situation is to pay more than your monthly payment, bringing the principle down fast and gaining 20% equity sooner.
• Single-Premium mortgage insurance - This is when you pay for the mortgage insurance in a lump sum up front. The benefit here is that you can pay for it at closing or lump the cost into the principle of your loan. This could lead to a lower monthly payment (compared to having the added cost on top of your monthly mortgage payment), however, you will be paying for it over the entire life of the loan. It’s also not likely that you will have the lump sum available if you aren’t able to pay the 20% down that is needed to avoid PMI completely.
• Lender-Paid mortgage insurance - In this situation, the lender pays for the mortgage insurance and passes the cost on to you, usually through higher interest rates¹. This means you cannot cancel the mortgage insurance on your loan in order to lower your monthly payment because the cost is added to your loan amount. The benefit here is that your monthly payment may be a little lower, allowing you to borrow more if needed.
• Split-Premium mortgage insurance - While not common,this option allows you to pay some of the payment up front and pay the rest monthly. The benefit with this one is that it allows you to keep your monthly payment down, and lessens the amount you have to pay up front compared to single-premium mortgage insurance. According to Investopedia, this option works best for people with high debt-to-income ratios who are trying to limit their monthly payments².

Do all home loans require Private Mortgage Insurance?

Private mortgage insurance only applies to conventional loans. However some loan types have fees attached to them that are similar and carry a different name. Here’s a breakdown of what you’ll find.

• Federal Housing Administration (FHA) loans - FHA loans do not require private mortgage insurance since they are backed by the government. They do still have Mortgage Insurance Premiums (MIP) that require an upfront payment and a monthly premium. If you put down more than 10%, this monthly premium will go away after 11 years, however, if you put down less than 10%, you cannot get rid of the premium unless you refinance.
• VA backed loan - VA loans do not require mortgage insurance and are backed by the Department of Veterans’ Affairs. However, you will still have something called an upfront “funding fee” which ranges from 1.4% to 3.6% of the loan, according to Nerdwallet.³ It will vary depending on factors such as your type of military service, disability status, down payment, buying a home or selling, and whether or not this is your first VA loan.
• US Department of Agriculture (USDA) loan - Similar to FHA loans, USDA loans have a “guarantee fee” which includes an upfront and monthly payment. You could roll the upfront fee into the mortgage if you don’t have the money to put down.⁴

How can you avoid paying mortgage insurance?

To avoid paying for private mortgage insurance on a conventional loan, you really have only two options.

1. Put down 20% or more as a down payment.
2. Get a piggyback mortgage - this is when you get two mortgages, one for 80% of the purchase price and another for 10%. You then put down 10% of the purchase price of the home from your personal savings and use the 10% loan to complete the 20% you need as a downpayment. This helps you avoid paying PMI monthly, but gives you two mortgages you’ll be paying.

How long you end up paying for PMI varies widely depending on the terms of your loan. On average, you would gain 20% of the value of your home around 8 to 10 years into a 30 year mortgage with no down payment. The bigger your down payment, the faster you’ll gain 20% and have the opportunity to get PMI canceled.

If you already have a mortgage with PMI and would like to get out of paying it, you have a few options.

• Reach out to your lender - If you have reached 20% equity in your home you could reach out to your lender and request the PMI payment be removed.
• Wait for equity to build - Once you have reached 22% equity in your home (you’ve paid off 22% of the home's value) the bank or lender is legally required to cancel your PMI payment.⁵ Keep in mind that this is only true for conventional loans with private mortgage insurance, and does not necessarily apply to USDA loans or FHA mortgage insurance premiums.
• Refinance - If terms have gotten better and you believe that you owe less than 80% of the home's value, refinancing could get you a better or comparable rate without the cost of PMI added to your monthly payment.
• Get an appraisal - You may not have paid off enough of your original purchase, but if the value of your home has gone up, getting an appraisal could show that you own more than 20% of the home’s value. This would allow you to get PMI removed from your loan.

How is mortgage insurance calculated?

PMI is calculated as a percentage of the purchase price of the home. It can be anywhere between 0.5% to 3%, depending on two factors:

• Down payment amount - The larger the down payment, the lower the risk for the bank, which means you’re more likely to get a lower rate on your PMI. For example, if you only put 3.5% down on the loan, you’ll probably pay somewhere closer to the 3%, but if you put 15% down, you’ll probably pay somewhere around the 0.5% side of the range. This will all depend on the lender as well, so be sure to check what they offer and compare what a larger down payment could save you in the long run.
• Credit score - Just as your credit score is considered for approval on the loan, it will also be considered when setting the rate of your PMI.

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