Many buyers have a difficult time understanding the concept of mortgage insurance – and most have a harder time comprehending the rules and regulations associated with it. I’ve put this quick primer together in hopes that mortgage insurance can be a little easier to understand.
Mortgage insurance allows a wide variety of people to become homeowners who otherwise might not be able to in the short term. Many borrowers would like to put down as little money as possible, but they will want to consider the real costs now and down the road.
In essence, here’s the system works: the larger the down payment, the better your financing deal. You’ll get a lower mortgage interest rate, pay fewer fees and gain equity in your home more rapidly.
Ultimately it’s a matter of balancing your short-term financial capabilities with the realities of your local real estate market…as well as your future savings and earnings potential to determine the best long-term financial result for you.
While both private mortgage insurance (PMI) and FHA insurance (MIP) provide lenders with a way to reduce the risk on a mortgage with a low down payment, they work differently when it comes upfront fees and cancellation down the road.
Most FHA mortgage insurance cannot be removed unless you refinance, while borrowers paying PMI on conventional mortgages can eliminate those costs once they reach a certain level of equity.
Secondly, the FHA mortgage is backed by the federal government through the bureau of Housing and Urban Development (HUD). Conventional mortgage backed insurance, on the other hand, is provided by private financial institutions.
The purpose of mortgage insurance is to reduce the cost to lenders if borrowers end up in foreclosure.
According to the Mortgage Bankers Association, foreclosures cost lenders 30 to 60 percent of the outstanding loan balance.
With this statistic in mind, it’s clear that a small down payment won’t do much to offset this loss for the lenders. And without insurance, lenders might not be willing to provide loans to buyers who have smaller down payments.
Lets take a look at both types to better understand how they work.
Private mortgage insurance (PMI) is for conventional (non-government) mortgages. Applicants must be approved by both the mortgage lender and the mortgage insurer.
Typically, lenders and investors require mortgage insurance for loans with down payments of less than 20%.
For the risk of that smaller down payment, the insurer collects a premium from the lender, who then typically recovers the cost of the premium from the borrower. The “risk” in private mortgage insurance is that a borrower may default on a loan, and that may ultimately result in the insurer having to pay a claim.
The cost for coverage depends on your down payment, the mortgage program, your credit score and the type of coverage you choose. The most common option is a monthly premium. It’s less costly at the outset, and it can be canceled when your loan balance drops to 80 percent of the home’s purchase price.
Premiums are calculated by using an annual rate, and then dividing by 12. Annual rates are usually about 1 to 2 percent of the outstanding principal amount of the loan.
Private mortgage insurance is not mortgage life insurance, which pays off a mortgage if the homeowner dies or becomes disabled. It is not homeowners’ insurance, which protects homeowners from loss due to theft, fire or other disaster. Private mortgage insurance protects the lender and investor from loss, not the borrower.
Consider borrowers who purchase a $200,000 property with a fixed-rate mortgage. They make a 10% down payment and are required to use mortgage insurance to finance a $180,000 mortgage.
Typically, on a 90% LTV, fixed-rate mortgage, investors require 25% coverage, meaning, in the event of a claim, the mortgage insurer is responsible for paying 25% of the outstanding loan balance, leaving the lender at risk for 67.5%.
On an uninsured loan, the lender is at risk for the entire loan balance.
If, down the road, borrowers fail to repay their mortgage, the lender or investor files a claim based on the unpaid loan balance, delinquent interest and foreclosure costs.
On most loans with private mortgage insurance, lenders must automatically cancel coverage when the loan reaches 78% of original value through amortization.
Borrowers may be able to cancel private mortgage insurance by making extra payments to bring the loan below 80% of their home’s original value. Borrowers may also request cancellation based on a new appraised value. When your borrowers are ready to cancel, they should contact their loan servicer for a full description of cancellation requirements.
FHA MIP, or mortgage insurance premium, is a type of insurance policy that protects lenders if an FHA loan holder defaults on his or her mortgage.
This insurance allows lenders to issue FHA loans requiring very small down payments and at low rates. FHA MIP reduces lender risk, and the benefits are passed onto the borrower. FHA mortgage insurance is generally not cancellable, like private mortgage insurance.
Removing FHA insurance is one of the major ways you can save money on your mortgage, but in many cases you’ll have to refinance into a different mortgage to eliminate your premiums.
If you started an FHA mortgage in 2013 or later with less than 10% in down payment, then you won’t be able to remove mortgage insurance unless you refinance out of the FHA loan program.
Mortgage insurance costs borrowers money, but it enables them to become homeowners sooner by reducing the risk to financial institutions of issuing mortgages to people with small down payments.
Many borrowers find it worthwhile to pay mortgage insurance premiums if they want to own a home sooner rather than later. Adding to the reasons for doing this: private premiums can be canceled once home equity reaches 80% if they are paying monthly PMI.
However, you might think twice if you’re in the category of borrowers who would have to pay FHA insurance premiums for the life of the loan. While you might be able to refinance out of an FHA loan later to get rid of PMI, there’s no guarantee that your employment situation or market interest rates will make a refinance possible or profitable.
In addition to the down payment for your new home, you’ll also have to pay closing costs — miscellaneous fees charged by those involved with the home sale
Arizona Phone: 480.788.2658
California Phone: 909.375.3319
Thomas Eugene Bonetto
Mortgage Loan Originator
NMLS: 1431961
Tom Bonetto has been helping his customers and players achieve their best for nearly 30 years. His goal is to provide both a superior customer experience and tremendous value for both his business associates and his players alike.
The views expressed are my own and do not necessarily reflect those of Guild Mortgage.
