Usually, a 20% down payment is recommended when purchasing a home. Even if a borrower doesn’t have a significant down payment, they may still be approved for a mortgage. But this approval may come with additional costs such as mortgage insurance.
So, what is mortgage insurance? How does it work? What do you need to look for? Before you begin shopping and comparing policies, here are the 5 things you need to know about mortgage insurance.
Quick Article Guide:
- Mortgage Insurance Protects the Lender
- Different Types of Mortgage Insurance
- Many Factors Go into Calculating Mortgage Insurance Premiums
- Cancelling Your Mortgage Insurance Policy
- The Bottom Line
Mortgage insurance, also commonly known as a mortgage guarantee, minimizes the risk for lenders if the borrower were to default on the loan. This insurance policy can compensate a financial institution if the borrower were unable to pay back the debt. Essentially, this insurance policy protects the lender.
According to the Down Payment Report, 60% of first-time home buyers put 6% down or less on their home. Many first-time home buyers may not have enough for a 20% down payment, which most likely would require them to purchase mortgage insurance.
Private mortgage insurance, or PMI, is used to protect conventional loans. When people talk about mortgage insurance, they are often referring to PMI. Here are the other types of PMI you should be familiar with:
Borrow-Paid Mortgage Insurance
One of the most common private mortgage insurance policies is borrower-paid mortgage insurance (BPMI). Your BPMI premium is tacked onto your mortgage payment every month.
The percentage you pay is based on the appraisal value of your home or your home’s original purchase price.
Single-Premium Mortgage Insurance
Just like the name sounds, you pay a single premium in full when paying your closing costs. You may also be able to lump this premium into your mortgage payment depending on the lender.
The benefit of single-premium mortgage insurance (SPMI) is that it tends to have a lower premium. However, if you choose to refinance or sell your home, you may not receive a refund.
Also, if you don’t have a 20% down payment, you may not be able to afford the lump-sum premium. You can always ask the seller or builder if they would be willing to pay all or a portion of your mortgage insurance. You never know how motivated they are to sell their home.
Lender-Paid Mortgage Insurance
Lender-paid mortgage insurance (LPMI) factors your premium into your total mortgage amount in the form of increased interest. This means you will pay your premium over the course of your loan repayment.
Unfortunately, with LPMI you will not be able to cancel your mortgage insurance. The only way to do so would be to refinance your loan to get a lower interest rate.
Keep in mind, your monthly interest rate may still be lower than paying a PMI monthly premium.
Split-Premium Mortgage Insurance
Split-premium mortgage insurance combines a lump-sum payment at closing and a monthly premium payment. Borrowers often choose SPMI if they have a high debt-to-income ratio.
Your lump-sum premium amount may range from 0.50% to 1.25% of your loan amount. Your monthly premium is based on your net loan-to-value ratio.
Mortgage Insurance Premium
Mortgage insurance premium (MIP) protects lenders in case borrowers were to default on government-backed loans. Since conventional loans tend to have stringent underwriting guidelines, many home buyers consider FHA loans due to their minimal down payment requirements.
MIPs tend to be a bit more complex and not as flexible as a PMI. With an MIP, you will need to pay an upfront premium as well as a monthly premium. The upfront premium tends to be a part of your closing cost when purchasing your home.
Once you’ve determined you need mortgage insurance, you should understand how mortgage insurance premiums are calculated. Your mortgage insurance premium is based on several key factors including:
- If you have a fixed or adjustable interest rate
- Your loan term (15 to 30 years)
- Your down payment amount
- Your credit score
- Which premium plan you choose
- Your loan-to-value ratio
- The amount of mortgage insurance required by the lender
- Whether the premium is refundable or not
- Any additional risk factors such as a second home or investment property
Generally, the riskier you are in any category, the higher your premium will be.
Your mortgage insurance premiums are typically about 0.17%-2.81%. A standard amount tends to be about 1% of your loan value. Let’s say you’re purchasing a $200,000 home with a 5% down payment. This would leave you with a $190,000 mortgage.
If your PMI was 1%, this would this would equal $1,900 a year, or $158 a month. This may seem like a significant amount to pay monthly, that’s why it’s important to factor mortgage insurance premiums into your budget. You wouldn’t want to end up in a situation where this additional expense caused financial distress.
If your FHA loan was opened after June 2013, you have a 30-year mortgage, or you put less than 10% down on your home, you may not be eligible for cancellation. However, refinancing may be an alternative option that will allow you to drop your mortgage insurance. There are no prepayment penalties on FHA loans – this means you could refinance at any time. Keep in mind, you must have a loan-to-value ratio of 80% or more in order to refinance.
If you received your FHA loan before June 2013, you may be eligible for cancellation. But you must have over 22% equity in your home and have made timely payments.
With conventional loans, lenders are required by law to drop your insurance once you reach a 78% loan-to-value ratio. It’s important to note that most lenders base your loan-to-value ratio on your most recent appraisal.
Another option is to refinance your current conventional loan. You won’t be required to pay for new PMI if your mortgage is 80% or less of the value of your home. Speak with your lender about requirements before proceeding.
Navigating the home buying process can be a struggle. That’s why it’s important to understand all the intricacies of purchasing a home. You may be required to purchase mortgage insurance if you don’t have a 20% down payment. So, before you begin browsing the housing market, make sure you understand the financial obligations of buying a home.
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Even if you have a substantial down payment, protecting your mortgage may be a good idea. You don’t want your family to inherit the financial burden of your mortgage in case of your absence.
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