Q: My real estate agent was helping me work out a budget for my first home purchase and insisted that I include the cost of mortgage insurance. I have really good credit, so maybe I’m not understanding how mortgage insurance works. Will I need it? What does it really do?
A: Your real estate agent is wise to encourage you to include mortgage insurance in your budgeting plan—not because you’ll absolutely need it, but because you won’t know for sure until you complete your budget and figure out what kind of loan you’ll take. But don’t be offended or take it personally—mortgage insurance requirements aren’t solely based on your credit, and in some cases the requirements aren’t related to credit at all. But what is mortgage insurance?
While the term “mortgage insurance” sounds a lot like other types of policies you may hold, like homeowners insurance, health insurance, or auto insurance, it’s not quite the same. Those policies are intended to protect you financially should you experience a theft or disaster, become ill, or become involved in a car accident. They reimburse the policyholder for related expenses caused by covered events. Mortgage insurance doesn’t protect the borrower; it protects the lender. Home loan lenders determine which borrowers are least likely to default on their mortgage payments, but there’s always a risk to the lender that something will happen and the mortgage company will be left with a large uncollectible debt. Therefore, if a down payment doesn’t reach the lender’s standard or if the borrower chooses certain types of loans, the borrower may be required to pay mortgage insurance, which provides mortgage protection for the lender. As you learn about mortgage insurance, you’ll see two acronyms: PMI, which stands for private mortgage insurance, and MIP, which stands for mortgage insurance premium. They’re similar in function, but quite different in how they’re included in home loans.
Mortgage insurance helps borrowers qualify for a loan under certain circumstances while protecting lenders if the borrower defaults.
Most people have heard at some point or another that they need to have a 20 percent down payment and perfect credit in order to purchase a home. While that may once have been the case, contemporary housing prices make those standards difficult, if not impossible, to reach for many buyers. As a result, most lenders have reduced their requirements for loans overall, and federal, state, and local governments have implemented programs to help buyers who are less qualified get into a home sooner—higher rates of homeownership are good for the economy, and the government wants to encourage people to buy. Still, even if a lender wants to offer a loan to a buyer who comes close but doesn’t quite meet the lender’s standards, the lending company takes on a tremendous risk. Requiring borrowers to purchase mortgage insurance serves two purposes: It helps buyers who are likely to be able to make their payments on time buy a home (even if their credit isn’t ideal or their down payment is low), and it covers the lender in case a borrower does default by insuring them for the balance of the unpaid loan.
There are some local programs that provide loans to borrowers with low down payments that don’t require mortgage insurance. These programs are often administered through local banks and require the borrowers to be current residents of the locality or state in which the program is offered. These are worth looking into if available, because the money that the borrower can save on mortgage insurance can reduce the time it takes to pay off the mortgage. However, it’s important for buyers to take a close look at all the terms of the loan and make sure they’re not paying a higher interest rate over the life of the loan, which might negate any savings.
There are two types of mortgage insurance, and the type you need depends on the type of loan you take out.
Some questions about mortgage insurance can’t be answered until the borrower has determined what kind of mortgage loan they’ll choose. If they qualify for a conventional mortgage, have great credit, and have a down payment of 20 percent of the cost of the home, they may be able to choose a mortgage that doesn’t involve mortgage insurance at all. Many borrowers have great credit but haven’t been able to save a 20 percent down payment, which is understandable—high rents, student loan debt, and other expenses can make it difficult to save. Those borrowers must demonstrate that they’ll be able to make their monthly payments and still have a comfortable cushion; in this case, they may be offered a conventional loan with the caveat that they purchase PMI, or private mortgage insurance.
For borrowers with lower credit scores, lower income overall, or very small down payments, an FHA loan may be the right choice. FHA loans are offered by lenders in cooperation with the Federal Housing Authority, which guarantees the loans so that the overall risk to the lender is reduced. To offset the cost of this program, FHA borrowers must pay an MIP, or mortgage insurance premium.
PMI is intended for borrowers who have a down payment of less than 20 percent, and it offers four payment options.
The “safety zone” for lenders is when the loan-to-value ratio (LTV) is 80 percent or lower—in other words, when the amount of money owed is less than 80 percent of the total value of the home. If the borrower has a credit score that meets the lender’s requirement, they can often choose a down payment of between 5 and 19.99 percent, as long as they’re willing to purchase private mortgage insurance. PMI usually works out to somewhere between 1 and 3 percent of the home’s purchase price, and the cost will be added on to the monthly mortgage payment every month until the LTV is lower than 80 percent. At that time, the lender is required to automatically cancel the PMI insurance as part of the Homeowners Protection Act. This act states that once the down payment plus the amount of the loan’s principal that the borrower has paid equals 22 percent of the home’s purchase price, the lender must automatically cancel the insurance so that the borrower isn’t paying for insurance that they’re not required to have. An additional benefit of the Homeowners Protection Act is that the PMI cancellation is tied to the purchase price of the home and not the current value, so even if housing prices have gone up and the actual market value of the home has increased, the cancellation of the PMI will be based on what the buyer paid. Borrowers can be proactive and request that their PMI be canceled when their equity reaches 20 percent, but it will automatically cancel at 22 percent as a fail-safe.
There are four types of PMI. The first, and most frequently used, is borrower-paid PMI. This is the standard form in which the borrower pays each month until they reach 22 percent equity, at which time PMI cancellation occurs automatically. Some lenders will allow cancellation earlier under certain circumstances; if the home’s value has changed significantly, the borrower may be able to have it appraised and petition the lender to release the PMI obligation sooner. Otherwise, the only way to cancel PMI before the necessary equity is reached is to refinance—but be careful to make sure the cost of the refinance isn’t more than the PMI costs.
Buyers who have extra cash when signing the mortgage documents may be interested in single-premium mortgage insurance. This option allows the borrower to pay the entire PMI premium up front in a single payment, rather than spreading it over the monthly payments. This is a less-common form of insurance, as the reason most buyers need insurance in the first place is because they do not have enough of a down payment to avoid it. In some cases, however, borrowers can roll the cost of the lump payment into the mortgage itself so they won’t have to come up with extra money. The benefit of this type of PMI is that it reduces the monthly payments, but the drawback is significant—if the borrower refinances or needs to sell the house, the up-front payment is not refundable, so the borrower will lose money in the transaction.
Even less common is lender-paid mortgage insurance. This sounds like a great deal—mortgage insurance that the lender pays sounds like the best kind! In reality, the lender will pay the cost of the PMI premiums in exchange for a higher interest rate over the life of the loan. Because the interest rate is one of the terms of the loan, not an add-on cost, lender-paid mortgage insurance can’t be canceled when the borrower reaches 20 percent equity; the borrower is stuck with the higher interest rate until the loan is paid off or they refinance. Because the monthly payments will be lower without the added PMI cost, buyers may be able to afford to borrow more, and if they can plan to refinance in a few years, this can be a money-saving option.
Split-premium mortgage insurance is the least-common type of PMI, but it can be useful in certain situations. If the borrower’s debt-to-income ratio is high, the lender will be looking closely at the total monthly payments to see what percentage of their monthly income will go toward debt payment. Increasing the mortgage by several hundred dollars per month with borrower-paid PMI may result in the lender refusing to loan enough money to purchase the home. Split-premium mortgage insurance is a shared system where the borrower pays a portion of the mortgage insurance up front—a smaller amount than they would pay with single-premium PMI, but enough to offset the amount of the monthly premiums, keeping the up-front costs lower than they would be with single-premium mortgage insurance, but reducing the monthly payments.
MIP is required for FHA borrowers and must be paid for the life of the loan.
FHA loans have a different set of requirements than other loan programs, including a different type of mortgage insurance. The FHA loan program was designed to assist borrowers with low down payments—as low as 3.5 percent for borrowers with credit scores higher than 580, and as low as 10 percent for borrowers with credit scores between 500 to 579. Traditional mortgage lenders usually require a credit score of at least 620, so this program is enormously helpful for buyers with little credit history or credit that’s being repaired. The FHA guarantees the loan, so the lender is at less risk—but in exchange, borrowers must pay MIP.
MIP is similar to PMI, but there are a few critical differences. First, like split-premium PMI, the MIP is paid in two parts: Borrowers will pay an up-front charge at the loan closing, and then they’ll pay a smaller premium each month on top of the regular loan payment. If a borrower is struggling to come up with the payment at closing, they will have the option to roll that payment into the loan amount, but then they’ll pay interest on it. The most significant difference between MIP and PMI, however, is that MIP cannot be canceled. The insurance is not contingent on how much equity a borrower has in the home, or their credit score, or the value of the home—quite simply, it is a cost that the borrower pays to offset the risk the lender and the FHA took when extending the loan. The only way to cancel MIP is to refinance the loan. If you previously had an FHA loan, this is a change; prior to 2013, the mortgage insurance on FHA loans could be canceled when equity reached 20 percent, just like PMI. The change made it easier for FHA borrowers to afford their monthly payments by lowering them with the up-front payment, but it locked in the monthly payments for the life of the loan.
VA and USDA loans don’t require mortgage insurance, but they do come with other fees that conventional or FHA loans do not.
Not all mortgage programs require mortgage insurance. Some local and state programs have programs aimed at buyers who might not otherwise be able to afford to buy a home in a way that does not include mortgage insurance. VA and USDA loans, which are federal programs administered through the U.S. Department of Veterans Affairs and the U.S. Department of Agriculture, have very specific requirements and do not include mortgage insurance.
VA loans are aimed at active or retired military service members and their families. The conditions of the loans address problems that are unique to military service members, such as the frequent need to change locations, sometimes without completing the sale of the previous home, and the years of earning and saving that military members have given up in the interest of public service. Often, no down payment is required, and favorable interest rates may be awarded. The VA backs the loans to reduce the risk to the lender. While VA loans don’t require mortgage insurance, they do require what is called a “funding fee,” which is paid at the closing of the mortgage. The funding fee can be rolled into the mortgage amount, which may increase the overall costs, but the benefit of not needing a down payment may make the slightly higher overall cost worthwhile.
USDA loans are geared toward moderate- and lower-income buyers who are willing to purchase a home in rural or less-developed areas. The goal of the loans is twofold: The USDA wanted to increase the homeownership rates in these areas to revitalize the towns, and by removing common obstacles to homeownership, such as large down payment and high credit score requirements, it realized it could entice buyers who met those conditions to populate and improve these rural areas. As a result, USDA loans are fairly high-risk for lenders; the borrowers are lower income, make little or no down payment, may have questionable credit, and the program requires lower interest rates and long repayment periods. Because the USDA guarantees the loans, lenders are willing to participate in the program. No mortgage insurance is required, but similar to VA loans, USDA loans require a funding fee. It’s small—the up-front premium at the time of closing is 1 percent of the loan amount, and then the annual funding fee, which will be paid each year through the monthly mortgage payment, is 0.35 percent of the remaining loan balance. The up-front fee can also be rolled into the loan amount.
Calculating the cost of mortgage insurance can give you a more realistic idea of your budget when shopping for a home.
There are lots of variables, but how much is mortgage insurance, really? It’s a good idea for buyers to try to work this out while they’re determining their budget for a home, because it can make a big difference in the monthly payment, and understanding the costs can help borrowers make decisions about how much home they can buy and how much they want to offer as a down payment.
With an FHA loan, the MIP cost will be based entirely upon the amount of the loan. The up-front payment will be 1.75 percent of the value of the loan. The monthly payments will be determined by the amount of money borrowed and the length of the repayment term, but this amount will be included in the closing documents and will not change over the course of the repayment term.
PMI is determined with a more complex calculation. The loan amount is still the base factor; in general, PMI costs will fall between 0.22 percent and 2.25 percent of the loan total. Where the borrower lands in this range will be based on their credit score and their LTV ratio. To estimate the insurance cost, the borrower needs to determine the value of the property (not the cost—the value, which is determined from an appraisal). The borrower needs to determine what their down payment will be and subtract that from the amount they plan to offer on the house; this is the loan amount. Here’s where it gets complicated: The borrower will need to figure out the LTV, which they can do by dividing the loan amount by the home’s value from the appraisal. They’ll then multiply that number by 100 to find the LTV. If the number is 80 percent or lower, no PMI will be necessary.
If the number is higher than 80 percent, the borrower will need to consult their lender’s PMI percentage chart or PMI rates. Most lenders have them available for borrowers to review. The borrower can also ask their lender for an estimated percentage based on their credit score and approximate loan amount. That percentage multiplied by the total loan amount will be the annual PMI premium. The borrower can then divide by 12 to see what the monthly payment will be.
If the borrower doesn’t have access to their percentage, they can use the numbers at the high and low end of the range to calculate their own range; they can perform these calculations using the percentage numbers of 0.22 and 2.25 to see the high and low possibilities. Based on the LTV and the borrower’s knowledge of their credit score, they can gauge where in the range they might fall.
Calculating the cost of mortgage insurance can help borrowers make better choices about how much they can afford to spend on a home, because budgeting for a mortgage isn’t just about the loan itself; the total monthly payments will determine how comfortably the borrower will be able to manage in the new house and connects directly to their likelihood of defaulting. The monthly payment will consist of a portion of the loan principal, the interest payment, the homeowners insurance—because lenders generally require borrowers to carry homeowners insurance to protect their collateral, and most lenders prefer that borrowers pay the for homeowners insurance as part of their monthly mortgage payment, which the lender will then use to pay the homeowners insurance premium—and the PMI or MIP. In addition, borrowers should consider approximate costs of utilities, food, clothing, and other necessities, along with other debt payments. Considering all of the monthly costs can help them figure out how much they can afford to spend. Guessing can lead to great difficulties after the home purchase.
Once the borrower has done the math to estimate their mortgage insurance cost and to see what their mortgage payment will be (including interest and the cost of the best homeowners insurance), they can start looking for a house they love that will fit into their budget.