How Does Mortgage Insurance Work?

If you’re considering buying a home but don’t have a 20% down payment, you’ll likely need to pay for mortgage insurance. This insurance protects the lender in case you default on your mortgage. In this article, we’ll explain what mortgage insurance is, how it works, and what you need to know before buying a home.

What is Mortgage Insurance?

Mortgage insurance is an insurance policy that protects the lender in case the borrower defaults. When you take out a mortgage, the lender takes on a risk by lending money to you, because there’s always a chance you could default on your loan. Mortgage insurance is a way for the lender to mitigate that risk.

If you don’t have a 20% down payment, you’re considered a riskier borrower because you’re borrowing more money. In this case, the lender requires you to pay for mortgage insurance. This insurance acts as a backup plan for the lender if you are unable to make your mortgage payments.

There are two types of mortgage insurance: private mortgage insurance (PMI) and government mortgage insurance. Let’s take a closer look at each type.

Private Mortgage Insurance (PMI)

Private mortgage insurance (PMI) is offered by private insurance companies and is required by lenders for borrowers who put down less than 20% of the home’s purchase price. PMI premiums are typically added to your monthly mortgage payments.

PMI rates vary depending on the size of your down payment, your credit score, and the loan-to-value ratio (LTV) of your mortgage. The LTV ratio is the amount of your mortgage divided by the appraised value of the home. For example, if you have a $100,000 mortgage and the home is appraised at $125,000, your LTV ratio is 80%.

PMI premiums can be cancelled once you reach 20% equity in your home. You can reach 20% equity by paying down your mortgage, making improvements to your home that increase its value, or a combination of both. The lender will automatically cancel your PMI when you reach 22% equity in your home.

Government Mortgage Insurance

Government mortgage insurance is offered by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and the United States Department of Agriculture (USDA).

FHA loans require borrowers to pay for mortgage insurance premiums (MIPs) for the life of the loan. The upfront MIP is 1.75% of the loan amount, and the annual MIP ranges from 0.45% to 1.05% of the loan amount, depending on the LTV ratio and the length of the loan.

VA loans require borrowers to pay a funding fee upfront, but they do not require monthly mortgage insurance payments.

USDA loans require borrowers to pay an upfront guarantee fee and an annual fee. The upfront fee is currently 1.0% of the loan amount, and the annual fee is 0.35% of the loan amount.

How Does Mortgage Insurance Work?

If you default on your mortgage, the lender can file a claim with the mortgage insurance company to recover some or all of their losses. The mortgage insurance company will then pay the lender a portion of the outstanding balance of the loan.

For example, let’s say you have a $200,000 mortgage with a 5% down payment, so you’re required to pay for PMI. Your PMI premium might be $100 per month. If you default on your mortgage when you still owe $180,000, the lender can file a claim with the mortgage insurance company for $36,000 (which is 20% of $180,000). The mortgage insurance company will then pay the lender $36,000, and the lender can use that money to offset their losses.

It’s important to note that mortgage insurance does not protect the borrower. If you default on your mortgage, you could still lose your home and damage your credit score.

FAQ

Here are some frequently asked questions about mortgage insurance:

Conclusion

Mortgage insurance is a necessary expense for many borrowers who don’t have a 20% down payment. It protects the lender in case the borrower defaults on their mortgage. There are two types of mortgage insurance: private mortgage insurance (PMI) and government mortgage insurance. PMI can be cancelled once the borrower reaches 20% equity in their home. Government mortgage insurance has different requirements and costs.

If you’re considering buying a home, make sure you understand the costs and requirements of mortgage insurance before you apply for a loan.