What is Mortgage Insurance and Why do you Need it?
Have you ever been researching home loans and heard the term “mortgage insurance” only to have your eyes glaze over as you tried to research just what exactly this mystical item was and how it could impact your next home purchase? Worse yet, have you ever come across the term in your closing documents on that same purchase, next to a large dollar amount, without knowing what this fee represents? Never fear, we’re here to break down into simple terms everything you may need to know about this lurking fee. That knowledge may help you make important decisions when it comes to financing, or refinancing a home, and could potentially help save you money.
Private Mortgage Insurance
In the most basic terms, federal lending guidelines require that every time you finance or refinance a home without paying 20% of the purchase price towards down payment, you will be required to purchase mortgage insurance. This will also sometimes be referred to as a Loan to Value Ratio (more to come on that later.)
The word insurance here can be a bit of a misnomer. The buyer, that’s you, isn’t actually receiving a benefit from the mortgage insurance. This insurance benefits your bank or lender, by guaranteeing that they will receive some repayment if you end up defaulting on your loan. The theory is that this encourages lenders to make loans to those who may not be able to come up with the funds needed for a traditional down payment.
Private mortgage insurance specifically refers to the type of mortgage insurance you will pay when you finance your home with a conventional loan and not through one of the various FHA or other government programs. The typical cost of private mortgage insurance will depend on your lender, your credit history, your down payment percentage and your total loan cost, but will typically be .5% to 1% of the cost of your loan per year. This payment will be an additional cost on top of your monthly loan amount.
FHA Required MIP
When it comes to an FHA loan, or loans that are insured by the U.S. Federal Housing Administration, mortgage insurance can get even trickier, and costlier. The benefits of taking out an FHA can be numerous for certain buyers. Down payments as low as 3.5% and credit requirements that allow borrowers with lower credit scores to qualify for loans, means that more people can achieve the dream of home ownership.
In return for these “riskier” lending practices however, the government requires not one, but two separate mortgage insurance payments, also called mortgage insurance premiums for FHA loans. First, you will be required to pay one upfront mortgage insurance which is due at the time you close on your home. The rate for this changes from year to year, but right now it is currently 1.75% of the borrowed amount. In addition to the upfront payment, you will also be required to pay an additional mortgage insurance premium on a monthly basis. The rate for this payment is currently .85% of the borrowed amount.
How to Eliminate Mortgage Insurance
Now that we’ve defined what mortgage insurance is, and how it can add big cots to your monthly mortgage payment, let’s talk about how to get rid of it. The good news is that homeowners can get rid of both their PMI for private loans and their MIP for FHA backed loans. The process for each, however, will vary.
For traditional loans, you can ask your lender to remove PMI payments once you have paid down your original mortgage balance to 80% of the home’s original appraised value. Once your mortgage balance is below a 78% of its original appraised value, your lender is obligated to remove the PMI requirement. This is where that loan to value ratio we mentioned earlier comes back into play.
You may be doing the math in your head and have figured that with your current low interest rate, that 80% or even 78% number seems pretty darn attainable. Unfortunately, the picture isn’t that rosy. Under most traditional loans, your interest is front-loaded, meaning that the loan is structured so that in the first years you will be paying a larger percentage of your payments to the total interest you will owe over the life of your loan and a smaller amount to the actual principal, which is what counts for the loan balance and your loan to value ratio.
With an FHA loan, getting rid of that PMI payment every month can get a bit tougher. For some older FHA loans, PMI may be able to be removed after five years but only if your loan to value ratio had hit a certain threshold. This means that even if you paid off a good chunk of principal, you would still be stuck with an extra PMI payment every month. For newer FHA loans, the PMI sticks with you for the life of the loan, regardless of your loan balance.
While these options may seem a bit daunting, don’t despair. Homeowners still have multiple options of getting rid of both PMI and MIP, if your loan and home qualifies. The most popular of these is a “simple” refinance into a conventional loan where your loan to value ratio exceeds the 80% threshold. For more discussion on whether a refinance is the right choice for you, check out our article on that exact topic here. In the meantime, hopefully we’ve helped demystify mortgage insurance which maybe, just maybe, will help save you big time on your next home finance and purchase.