What Is Mortgage Insurance?

25 Apr

If you’re in the market for a new home, your real estate agent or mortgage lender may mention private mortgage insurance (PMI). Private mortgage insurance is often required for a standard mortgage if you have less than a 20 percent down payment but there are programs available that can eliminate the need for or drastically reduce the cost of PMI over the life of your loan if you qualify.

Keep reading to learn everything you need to know about PMI as well as federal programs that may allow you to forgo PMI if you meet the requirements.

What Is Mortgage Insurance?

Private mortgage insurance (PMI) is designed to give lenders peace of mind that the mortgage will be paid even if the borrower defaults, it also helps borrowers qualify for a loan that they might not qualify for if they refuse to carry mortgage insurance. 

While lenders used to (many still do) require 20 percent down and a stellar credit score to qualify for a mortgage, as home prices have skyrocketed, the 20 percent threshold is getting harder, if not impossible, for new homebuyers to meet. Many lenders have reduced their mortgage requirements to allow borrowers to qualify for a loan, but that leaves them open to a higher risk of a default on the loan.

Mortgage insurance helps lenders feel comfortable writing these loans and allows the potential homeowner to qualify for a loan so they can purchase a house. If the borrower defaults, the mortgage insurance will pay the remaining balance on the loan to the lender, so their risk is covered.

Mortgage insurance and loan types

Mortgage insurance looks different depending on the loan type. Here are a few of the most common loan types and how PMI works with each loan:

Mortgage insurance for conventional mortgages

Lenders may offer conventional mortgages with smaller down payment requirements but if you have less than 20 percent, they will most likely require PMI. There are plenty of PMI 

calculators on the Internet which factor in your loan size, credit score and other factors to give you an idea of how much PMI will cost. Once you have 20 percent equity in the home you can drop the PMI.

FHA mortgage insurance premium (MIP)

An FHA loan will usually require a much smaller down payment than a conventional loan, in some cases it can be as low as 3.5 percent. However, the majority of FHA loans require an upfront PMI premium as well as an annual premium that must be paid. While it can vary, in most cases, the upfront premium is 1.75 percent of the loan amount while the annual premium varies between 0.45% to 1.05% of the average outstanding balance of the loan for that specific year. As an example, if you are borrowing $300,000 the upfront premium would be $5,250 and the annual premium would run $1,350 to $3,150 a year. 

FHA loans require that you pay the annual mortgage insurance premium for the life of the loan if you put down less than 10 percent. If your down payment exceeds 10 percent, you must pay the annual premium for 11 years. 

USDA guarantee fee

The USDA provides loans that are zero down payment loans for people purchasing a rural home. Like an FHA loan, these loans often come with two fees, an upfront fee that you pay once at the start of the loan and an annual fee that must be paid every year for the life of the loan. In 2019, the upfront part of the loan was 1 percent of the loan amount while the annual fee came in at 0.35% of the average outstanding loan balance. The federal government sets the fee each year and it can change but once the loan closes the fee will stay the same over the life of the loan.

VA funding fee

VA mortgages are available to active, disabled, retired military service members as well as some National Guard members and reservists, Eligible surviving spouses can also get a VA mortgage which has a zero down payment and low interest rates. A VA loan won’t require mortgage insurance but there is usually a funding fee that ranges from 1.4 to 3.6 percent of the loan amount. 

Cancel mortgage insurance at 20 percent

Once you have reached 20 percent equity in the home you should cancel your PMI, but even if you forget, your lender will do it automatically once you get to 22 percent. The Homeowners Protection Act requires lenders to automatically cancel PMI when your equity in the home hits 22 percent, so homeowners are not paying for coverage they don’t need. 

The Homeowners Protection Act ties the PMI cancellation to the purchase price of the home, not the current value so even if the value of the home has increased since purchase, the PMI cancellation will be based on hitting the 22 percent on the purchase price. You can legally cancel PMI once you hit 20 percent equity.

Tips to avoid mortgage insurance

PMI insurance can get pricey and if you can avoid it, you should. Here are a few tips to avoid having to pay for PMI:

  • Local Programs: Many states and county’s offer first home buyer programs that offer mortgages with low down payments as well as relaxed lending requirements. Check with your local real estate agent or mortgage lender to see if these loans are available in your area. 
  • Save 20 percent: If you can afford to wait to purchase a home it may be a good idea to save up the 20 percent before you start shopping for home. This way you avoid PMI and will get the best loan terms as long as your credit score is solid. 
  • Federal Programs: As detailed above, the federal government offers a variety of mortgage programs for homebuyers that qualify. Check with your local mortgage lender and real estate agent to see if you qualify for a federal mortgage program. 

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