The Ins and Outs of Mortgage Insurance
The term “mortgage insurance,” not to be confused with homeowners insurance, can refer to two different types of coverage. Both protect against unexpected default, but one covers the lender if you stop making payments (typically known as private mortgage insurance or PMI) and the other allows you or your beneficiaries to pay off your mortgage in the event of your disability or death (typically known as mortgage life insurance).
This post deals with private mortgage insurance and its FHA, VA and USDA equivalents.
Why DO I Need mortgage insurance?
Lending institutions grade borrowers based on risk factors like credit score, amount of debt compared to income, employment history, and down payment percentage.
For example, a borrower with a high credit score, stable employment and little debt putting 20% down (Borrower A) is considered to be a lower risk client and will receive more favorable terms than the same borrower putting 10% down (Borrower B) or 0% down (Borrower C). Statistically, Borrower B is almost twice as likely to default compared to Borrower A, and Borrower C, is almost three times as likely to default as Borrower A!1
That’s where mortgage insurance comes in. The bank is still willing to invest in Borrowers B and C for a higher return (in this case, a higher interest rate) but wants additional protection in case Borrowers B and C fail to repay their entire loans. Borrowers B and C pay an additional monthly amount to insure the bank’s investment – i.e. mortgage insurance.
What type of payment Should I Choose?
There are three main options when it comes to paying mortgage insurance: lender-paid mortgage insurance, borrower-paid mortgage insurance paid monthly, and borrower-paid mortgage insurance paid in a lump sum at closing.
In exchange for a higher interest rate, the lender pays the mortgage insurance premium. This typically results in a lower monthly payment over the first few years of the loan compared to paying the mortgage insurance monthly. However, the mortgage insurance cannot be eliminated no matter how many payments are made or how much equity is gained, therefore this is the most expensive option over the life of the loan.
The borrower pays the mortgage insurance as part of their monthly payment. The monthly payment is typically higher upfront than lender-paid insurance, but depending on the type of loan and amount of down payment, the mortgage insurance may eventually be removed, thus saving money over the life of the loan.
SINGLE PREMIUM BORROWER-PAID
The borrower pays the mortgage insurance premium in a lump sum at the time of closing. This significantly reduces the total cost of the mortgage insurance. Since the entire amount is paid upfront, the mortgage insurance cannot be removed. This is the least common choice as most borrowers who are putting less than 20% down want to reduce their upfront investment as much as possible.
FHA, USDA and VA loans require an upfront premium. FHA and USDA’s upfront premiums are in addition to, not in lieu of, the monthly payment. VA loans only have the upfront fee and no monthly premium. In all three cases the upfront premium can be paid out of pocket at closing or rolled into the loan amount (financed).
How Do I Get rid of mortgage insurance?
How quickly you can remove your mortgage insurance (and whether you can get rid of it without refinancing) depends on the type of loan and how much money you put down at the time you purchased the home.
With lender-paid and single premium borrower-paid mortgage insurance, the insurance cannot be removed. With monthly borrower-paid mortgage insurance, the premium can be removed early once there is at least 20% equity in the home, whether through making monthly payments, an increase in the appraised value or a combination of both. Once there is 22% equity in the home, the mortgage insurance will automatically be removed.
As of 2013, FHA tightened the requirements to removing mortgage insurance. Now, if a borrower puts less than 10% down payment, the mortgage insurance will continue for the life of the loan. If a borrower puts more than 10% down payment, the mortgage insurance will be removed after 11 years.
The guarantee fee (USDA’s equivalent of mortgage insurance) continues for the life of the loan.
VA loans do not have a monthly mortgage insurance, just the upfront funding fee.