Mortgage insurance is a product purchased by the home buyer designed to protect the lender from the risk involved in funding the mortgage. Private mortgage insurance essentially protects the lender in the event of a borrower defaulting on a loan and being unable to repay the debt. The insurance covers the difference between the fair market value of the home and the actual price a lender may be able to sell the property for, in case of a default on the loan. Basically, it allows lenders to recover their investment, even if the property’s worth is not enough to pay off the loan balance.
While there are several types of mortgage insurance, the types that everybody complains about are private mortgage insurance (PMI) on conventional loans and Mortgage Insurance Premiums (MIP) on Federal Housing Administration (FHA) loans. That's because homeowners paying for mortgage insurance have to pay a hefty premium for an insurance policy, and it covers the lender, not them.
Most borrowers don’t have any choice when it comes to PMI. If your down payment is less than 20% of the sales price of your home, your lender will require a policy and arrange the contract for you. It makes sense: the less a borrower puts down, the higher the risk to the lender, so the lender wants insurance against a default.
Although homebuyers generally want to avoid PMI given the cost, it does have its upside. Many borrowers, especially first-time homebuyers, cannot afford a 20% down payment in the current economic climate. Without PMI, people wouldn’t be able to borrow as much as they can now. Without an additional safeguard, lenders would have no incentive to offer loans with down payment requirements as low as 3%. Instead of saving up for a 20% down payment that could take years, private mortgage insurance offers homebuyers access to mortgages much sooner.
How much is mortgage insurance
Private mortgage fees can vary, though borrowers typically pay a monthly charge of approximately $40- $50 per $100,000 borrowed. For instance, someone with a $300,000 home loan can anticipate private mortgage costs being around $120- $150 per month. The larger your loan, the higher the PMI, so make sure to factor this fee into your home buying calculations.
PMI origination fees and monthly premiums change frequently. Check with your mortgage lender for more specific information about PMI expenses on your mortgage.
Even though the rates of the PMI maybe fairly similar between different insurance providers they could differ from state to state, between different areas and are subject to market conditions. Sometimes certain areas that are considered to be distressed property areas where the values of real estate is declining, such as in parts of California and Nevada, are charged a higher PMI rate. Similarly limited documentation mortgages and mortgages with less than 5% down payment will get charged a higher origination fee as well as higher rates on the private mortgage insurance.
Mortgage insurance on an FHA loan is a different animal, however. The FHA currently charges an upfront mortgage insurance premium (UFMIP) that’s equal to 1.75% of a home’s value for most new mortgages. You can typically roll this fee into your total loan balance. On top of that, the FHA levies a yearly fee that varies based on how large of a down payment you placed when you took out your mortgage:
- 30-year loan term, LTV less than or equal to 95%. 1.30% annually
- 30-year loan term, LTV greater than 95%: 1.35% annually
How to avoid mortgage insurance
There are several ways to completely avoid paying for private mortgage insurance:
- You can put down 20% or more as a down payment on the home. That’s always the easiest way to get rid of PMI, but not everyone can afford such a hefty sum.
- You can pay a higher interest rate. Some more lenders offer you the option
of paying a higher interest rate in exchange for avoiding mortgage insurance, typically the increases range from .75% to 1%. The difference in your monthly payment spread out over your planned term of occupancy could be less than paying for mortgage insurance. Make sure you discuss this option with your lender if you’re interested. This method has an added bonus—unlike PMI, interest on a mortgage is tax deductible.
- You can take out a “piggyback loan”, like an “80/10/10” loan, which consists of a 10% down payment, an 80% first mortgage and a 10% second mortgage. For this type of loan, borrowers can opt to make a 10% down payment and secure a loan for 80% of the property’s total value, simultaneously securing a second loan (referred to as a piggyback mortgage) to cover the remaining 10% and avoid PMI. Some banks even offer 80-15-5 piggyback loans, in which borrowers only need a 5% down payment.
- If you are a veteran, you can get a VA loan, which has no private mortgage insurance. And if you’re shopping for a home in rural areas, make sure to look into USDA loans.
How to cancel mortgage insurance
The most common method of getting out from under PMI is actually paying off your mortgage. It might not be groundbreaking advice, but once you get to 22% equity in your home your mortgage lender will be required by law to cancel the mortgage insurance policy on your home. In some cases you’ll even be eligible to cancel at 20% ownership. Most lenders will require an independent appraisal before they cancel any mortgage insurance policy. You likely won’t have a choice in the appraiser or the amount that the appraisal will cost you, which is usually between $350 and $500.
If you have an FHA loan, you will need to pay down your mortgage to 78% of your original sales price. Even if appreciation has pushed your equity up, it won't matter. You still will need to reduce your original principal balance. There’s even talk that the FHA might stop cancelling mortgage insurance altogether and make it a requirement for the full life of the loan, costing borrowers thousands and thousands of dollars over the life of their loan.
To determine whether you are ready to cancel PMI, use your appraisal to calculate your "loan to value" (LTV) ratio. This is a simple calculation -- just divide your loan amount by your home's value, to get a figure that should be in decimal points. If, for example, your loan is $200,000 and your home is appraised at $250,000, your LTV ratio is 0.8, or 80%.
Most lenders then cancel PMI, but some buyers find their lenders to be agonizingly slow to cancel the coverage. If your lender refuses, or is slow to act on your PMI cancellation request, write polite but firm letters requesting action. Such letters are important not only to prod the lender into motion, but to serve as evidence if you're later forced to take the lender to court. If court action becomes your best option, small claims court can be a good avenue, and you won't need a lawyer to accompany you.
While most borrowers hate the idea of paying for mortgage insurance, in the end most will agree it is necessary. Because of the steep cost though, most borrowers will do so reluctantly, hoping to get out from under mortgage insurance payments as quickly as possible. For the majority of borrowers doing so will come through building equity in their homes over time and finally cancelling the policy after they get to 22% equity. If you are in the boat, don’t fret, mortgage insurance might be costly, but without it getting a loan would have been probably impossible. It’s painful to pay for a policy that doesn’t protect you, but it did help convince the buyer to lend in the first place.