Introduction
Buying a home is an important milestone, but for most, it involves taking out a mortgage. One of the extra expenses that tend to accompany a mortgage—particularly if you put down a small down payment—is mortgage insurance. Although it seems like an extra expense that isn’t needed, mortgage insurance serves an important function in homeownership, allowing borrowers to qualify for loans with smaller down payments.
However, it’s essential to understand how mortgage insurance works, the different types available, and strategies to minimize or avoid its cost. This guide will provide a comprehensive overview of mortgage insurance, why it’s necessary, and actionable tips to reduce or eliminate it.
What Is Mortgage Insurance?
Mortgage insurance is an insurance policy that covers the lender in case the borrower defaults on the loan. Although it does not benefit the homeowner directly, it enables lenders to lend to buyers who do not have the usual 20% down payment needed for a conventional loan.
Mortgage insurance will not stop foreclosure or pay the borrower’s payments in the event of financial difficulty. Rather, it is a lender financial safety net that makes lenders more inclined to approve mortgages with lower down payments.
There are various forms of mortgage insurance, each associated with different loan programs.
Types of Mortgage Insurance
1. Private Mortgage Insurance (PMI)
PMI is mandatory in the case of traditional loans where the down payment is below 20% of the purchase price of the house. Private firms offer this sort of insurance and its cost changes depending on aspects like credit rating, loan, and loan-to-value ratio (LTV).
- Cost: It usually varies from 0.3% to 1.5% of the amount of the loan per year.
- Payment Options: Monthly premium, initial payment, or a mix of both.
- Cancellation: PMI can be canceled when you achieve 20% home equity, either by making regular mortgage payments or through appreciation in property value.
2. FHA Mortgage Insurance Premium (MIP)
FHA loans, which are insured by the Federal Housing Administration, pay Mortgage Insurance Premium (MIP) no matter what size down payment you make. Unlike PMI, MIP does not stop even if you make a down payment of 20% or more.
- Cost: There is both an upfront premium (1.75% of the loan) and an annual premium (0.45% to 1.05%).
- Duration: For the life of the loan if the down payment is under 10%, but can be cancelled after 11 years if you make a 10% or higher down payment.
3. VA Funding Fee
For active-duty and veteran service members, VA loans do not have PMI or MIP. They are instead subject to a one-time VA funding fee, which assists in keeping the VA loan program running.
- Cost: 1.25% to 3.3% of the loan value, depending on the size of the down payment and whether it’s a first-time or repeat VA loan.
- Exemptions: Disabled veterans with service-connected disabilities can be exempt from the funding fee.
4. USDA Loan Guarantee Fee
The U.S. Department of Agriculture (USDA) provides loans for suburban and rural homebuyers without PMI. They charge a guarantee fee in place of mortgage insurance.
- Upfront Fee: 1% of the loan.
- Annual Fee: 0.35% of the loan balance.
These charges make USDA loans an affordable choice for eligible borrowers in targeted areas.
Why Is Mortgage Insurance Necessary?
Mortgage insurance has the main purpose of protecting lenders from loss if a borrower defaults. It also helps homebuyers by making homeownership more affordable. Here’s why:
1. Helps Borrowers with Limited Savings
Most individuals, particularly initial homebuyers, find it difficult to save 20% down payment. Mortgage insurance enables them to finance homes with 3% to 5% down, which will help them own a home earlier than waiting years to be able to save enough.
2. Prompts Lenders to Provide Loans with Low Down Payments
Lenders are more likely to grant low-down-payment mortgages if they have an insurance safety net, which enables borrowers to get financing more easily.
3. Opens Up Homeownership Opportunities
Mortgage insurance keeps many would-be buyers from being shut out of the housing market. Millions of Americans gain homeownership annually through programs such as FHA and VA loans.
How to Reduce or Avoid Mortgage Insurance Costs
Mortgage insurance can add hundreds of dollars to your monthly payments, so it’s important to explore ways to minimize or eliminate this expense. Here are some strategies:
1. Make a Larger Down Payment
If you can, paying at least 20% gets rid of PMI on standard loans. Even though you might not be able to make it to 20%, a larger down payment will still lower your PMI charges.
2. Select the Proper Loan Program
- If you’re a veteran, apply for a VA loan, which does not call for PMI.
- If you are eligible for a USDA loan, you will not pay PMI, although there is a guarantee fee.
- If your credit score is excellent, a conventional loan might cost less in PMI than an FHA loan, in which MIP is mandatory for most borrowers.
3. Improve Your Credit Score
For conventional loans, lenders charge lower PMI rates for borrowers with good credit. Steps to improve your score include:
- Paying bills on time.
- Reducing credit card balances.
- Avoiding new debt before applying for a mortgage.
4. Request PMI Cancellation
If you have a traditional loan, after your home equity is 20%, you can ask for PMI cancellation. Lenders are required to automatically cancel PMI when the loan balance is 78% of the original purchase price.
5. Refinance Your Loan
If your home’s worth has increased or your finances have improved, refinancing might be able to help you drop mortgage insurance. Moving to a conventional loan from an FHA loan may be worthwhile if you qualify without PMI now.
6. Look at Lender-Paid Mortgage Insurance (LPMI)
Certain lenders provide LPMI, whereby they purchase the mortgage insurance at the cost of a marginally higher interest rate. This is an excellent choice if you’re likely to reside in your house for a long time.
Is Mortgage Insurance Worth It?
Though nobody likes paying additional fees, mortgage insurance can be a valuable tool for buyers who lack significant savings. It enables you to:
Purchase a home earlier rather than waiting years for 20% savings.
Take advantage of affordable financing opportunities with low-down-payment loans.
Enjoy home price appreciation while paying the mortgage.
But the trick is to be strategic in how you handle your mortgage insurance premiums. Knowing your choices, enhancing your credit profile, and selecting the correct loan can keep you from overpaying.
Common Myths About Mortgage Insurance
There are a number of myths regarding mortgage insurance that usually lead to confusion among homeowners. Knowing the truth behind these myths can guide you in making good decisions when acquiring a mortgage.
Myth 1: Mortgage Insurance Protects the Borrower
Most borrowers incorrectly assume that mortgage insurance shields them if they cannot pay their mortgage. Nevertheless, mortgage insurance serves to safeguard the lender, not the borrower. In the event of default, the insurance firm pays the lender for a portion of the amount owed on the loan.
Reality: To protect yourself, look into mortgage protection insurance (MPI) or life insurance, which can be used to pay for mortgages if you lose your job, become disabled, or die.
Myth 2: Mortgage Insurance Lasts for the Entire Loan Term
Some homebuyers believe that once they begin paying mortgage insurance, they’re locked into it for the duration of the loan.
Fact: PMI on traditional loans can be cancelled when you are 20% in equity. For FHA loans, MIP can be canceled after 11 years if you put down 10% or more. Otherwise, you can refinance to a traditional loan.
Myth 3: PMI and MIP Are the Same Thing
Though both PMI and MIP have the same function, they are not the same.
Fact: PMI is for traditional loans, whereas MIP is only for FHA loans and has varying conditions for cancellation and payment structure.
Myth 4: Mortgage Insurance Is Always Expensive
Mortgage insurance price fluctuates according to a variety of factors such as credit score, size of down payment, and type of loan. Some applicants consider it’s always too costly.
Fact: With enhanced credit scores and larger down payments, you are able to reduce the expense of PMI. Others also provide discounts or alternatives that can lessen the cost of mortgage insurance.
How Mortgage Insurance Affects Your Monthly Payments
Most home buyers don’t appreciate the impact that mortgage insurance will have on their monthly mortgage payment. Let’s dissect an example to determine what the actual impact is.
Example: Breakdown of PMI on a Conventional Loan Cost
- Home Price: $300,000
- Down Payment: 10% ($30,000)
- Loan Amount: $270,000
- PMI Rate: 0.5% (depends on credit score and lender)
Yearly PMI Expense: $270,000 × 0.5% = $1,350 annually
Monthly PMI Payment: $1,350 ÷ 12 = $112.50 per month
This extra expense mounts up over time, which is why dropping PMI as quickly as possible is a financially wise decision.
Sophisticated Strategies to Reduce Mortgage Insurance Fees
For homebuyers who want to be more strategic, here are advanced methods to save on mortgage insurance.
1. Utilize a Piggyback Loan (80-10-10 Strategy)
A piggyback loan is to obtain two distinct loans to steer clear of PMI.
- Primary mortgage: 80% of the purchase price
- Second loan (home equity loan or HELOC): 10% of the purchase price
- Down payment: 10%
This tactic disqualifies PMI since the main mortgage remains at 80% loan-to-value (LTV). Nevertheless, second mortgages tend to come with increased interest rates, so comparing costs first is important before deciding on this course of action.
2. Search for Lender-Paid Mortgage Insurance (LPMI)
Certain lenders provide LPMI, in which the lenders pay for the cost of the mortgage insurance but receive a somewhat higher interest rate.
Advantages: No PMI payments each month.
Disadvantages: You pay more interest in the long run.
If you anticipate living in your home briefly, LPMI may be a viable option for you.
3. Build Up Your Down Payment Incrementally
Even if you can’t afford a 20% down payment, paying 15% down rather than 10% can dramatically save on PMI fees. Some lenders have tiered PMI pricing depending on the size of the down payment.
4. Get a Reappraisal to Cancel PMI Earlier
If your home’s value has gone up significantly since buying, you may have 20% equity earlier than anticipated.
How to do this?
- Call your lender to ask for a new home appraisal.
- If your loan-to-value (LTV) ratio is currently under 80%, you can apply for PMI cancellation.
This tactic is particularly effective in rapidly growing real estate markets where homes appreciate rapidly.
