If you’ve ever tried to buy a home with less than a 20% down payment, you may have heard of mortgage insurance. This financial tool — whose primary purpose is to protect the lender — allows people to buy a home without making a large down payment.
Here, we’ll explore the ins and outs of mortgage insurance, what it is, how it works, the different types available, who needs mortgage insurance, and how it affects your monthly payment.
Explaining mortgage insurance
Mortgage insurance is a type of insurance that protects lenders if a borrower defaults on their mortgage loan. This is usually required for home buyers who have a down payment of less than 20% of the home’s total value. There are different types of mortgage insurance offered by private and government agencies.
When a borrower takes out a mortgage with less than 20% down, the lender may require the borrower to pay for mortgage insurance. The monthly cost of insurance is usually a percentage of the loan amount, which is added to the borrower’s monthly mortgage payment. Insurance coverage may vary depending on:
- Type of loan
- Size of down payment
- Creditworthiness of the borrower
Depending on the type of mortgage credit insurance, you may be able to cancel your mortgage insurance after you build up enough equity in your home.
Why do you need mortgage insurance?
If you want to buy a property but don’t want to – or can’t – spend 20% on a down payment, mortgage insurance is an excellent tool for you.
Lenders are less likely to approve loans with small down payments without mortgage insurance. This can make it more difficult for you to buy a home. So, if you don’t have the cash for a big down payment, you can still buy the home you want by paying a little more each month toward your mortgage.
Is it necessary?
Not all lenders require mortgage insurance. Some lenders may have their own internal policies that allow borrowers to make a down payment of less than 20% without requiring mortgage insurance.
Some government-backed loan programs, such as FHA loans, require built-in mortgage insurance. Lenders will usually finance these loans.
What are the types of mortgage insurance?
There are different types of mortgage insurance, each with unique features and requirements. This section will discuss the four main types of mortgage insurance: private mortgage insurance (PMI), mortgage insurance premium (MIP), USDA guarantee fees, and VA funding fees.
Private Mortgage Insurance (PMI)
Private financial institutions may require PMI for home buyers who cannot afford at least a 20% down payment. The cost of PMI is usually added to the monthly mortgage payment and can range from 0.3% to 1.5% of the principal loan amount per year. The exact cost of PMI will depend on several factors, including your credit score.
You can usually cancel your PMI once you’ve built up enough equity in your home. This usually happens when you’ve paid down enough of your debt to reach a loan-to-value ratio of 78% or less.
You may also have the option of paying a one-time premium for mortgage insurance instead of making monthly payments. This is known as LPMI (Lender-Paid Mortgage Insurance), and is a way to avoid paying monthly PMI.
Mortgage Insurance Premium (MIP)
MIP is required for Federal Housing Administration (FHA) loans. These loans are government insured and designed to help first-time home buyers and low-income people buy homes
MIP is generally more expensive than PMI. The cost of the MIP is usually added to the monthly mortgage payment and can be significant depending on the loan amount and down payment. Unlike PMI, which you can cancel when you reach a certain level of equity in the home, MIP is usually required for the life of the loan. This means that you have to pay MIP until you pay off the loan or refinance into another type of loan.
If you’re thinking about refinancing, read our guide on the best mortgage refinancing options and make sure you follow a mortgage refinancing steps checklist.
In addition to the monthly mortgage payment, you will be required to pay an upfront MIP at closing. This one-time payment is usually 1.75% of the loan amount.
USDA Guarantee Fee
The US Department of Agriculture (USDA) guarantee fee is required for home buyers looking to purchase a home in a rural area with a USDA loan. This type of loan is backed by the USDA and designed to help low- and moderate-income homebuyers in rural areas. The government offers USDA loans with higher credit and income requirements than conventional loans.
A USDA guarantee fee is also added to the loan amount, ranging from 0.35% to 2.75%. Lenders may be able to offer lower guarantee fees to low-income borrowers. But high-income borrowers may still pay higher fees.
Lenders use these fees to offset the costs associated with providing loans and to ensure the long-term sustainability of the USDA loan program. The fee is usually paid upfront at closing, but it can be financed with a loan.
VA funding fees
A VA funding fee is required for home buyers looking to purchase a home with a loan backed by the Department of Veterans Affairs (VA). This type of mortgage insurance is available to veterans, active-duty service members and spouses of service members – active or veterans. VA loans are offered by the government and have lower credit and income requirements than conventional loans. They also don’t require a down payment, making them a more affordable option for veterans and service members.
VA funding fees are added to monthly loan payments and can range from 1.4% to 3.6% of the loan amount.
Mortgage insurance benefits
It may seem like an extra expense, but mortgage insurance has several benefits if you’re trying to buy a home.
Low down payment: The biggest advantage of mortgage insurance is that it allows you to buy a home with a lower down payment. For conventional loans, a 20% down payment is usually required. Considering the current real estate market, this down payment can be quite significant. But with mortgage insurance, you can put 3% down and still get the home you want.
Cancellation: You may be able to cancel most types of mortgage insurance once you build up enough equity. This can add up to significant savings for you over the life of the loan.
Protection for Lenders: Mortgage insurance protects lenders and allows them to continue making loans. Loan defaults can happen, but this insurance allows lenders to maintain enough support to offer loans to you and other buyers.
Disadvantages of mortgage insurance
Like any financial product, mortgage insurance has its drawbacks. This section will discuss some of the disadvantages of mortgage insurance.
Additional Costs: The main disadvantage of mortgage insurance is cost. The cost of mortgage insurance is usually added to the monthly mortgage payment and can range from 0.3% to 1.5% of the principal loan amount per year. For some people, this extra cost can be a significant burden in the long run. Make sure you weigh the pros and cons and decide if you’d rather pay for a simple down payment or pay a few hundred extra dollars each month.
Not all types of mortgage insurance can be canceled: If you’re thinking about canceling your mortgage insurance, be aware that some types of mortgage insurance, such as FHA mortgage insurance, may require the borrower to carry the insurance for the entire loan term, regardless of their equity.
How much can you expect to pay?
The cost of mortgage insurance can vary depending on several factors: the type of loan, the size of the down payment and the borrower’s credit score. You can expect to add a small percentage of the total loan amount to your monthly payment. Below are the expected costs for different types of mortgage insurance.
The cost of private mortgage insurance can vary, but it is usually between 0.3% and 1.5% of the principal loan amount per year.
On the other hand, MIP costs typically range from 0.5% to 5% of the principal loan amount per year. There is also a one-time closing fee of around 1.75% of the loan amount.
For government-backed loans, the USDA guarantee fee is about 0.35% to 2.75%, and the VA funding fee is about 1.4% to 3.6%.
Not all mortgage insurance is permanent. Once you reach a certain level of equity, you can ask for the mortgage insurance to be removed. If your loan offers this feature, it can make buying a home more affordable than a loan that doesn’t. If you’re interested in this feature, research traditional loans with PMI.
Your next step
If you want to buy a home without committing to a large down payment, you need to know how to handle mortgage insurance efficiently. Here are the next steps you should take
- Understand the types of loan and mortgage insurance: Learn the difference between the types of insurance described in this guide to find out which one is best for you. Research the various loans offered by both private institutions and the government to find the one that best suits your needs. Finally, consider whether you need a traditional mortgage or a reverse mortgage. If you’re considering a reverse mortgage, review our guide to the best reverse mortgage providers
- Review your credit score: Before applying for a loan with a low down payment, you need to review your credit score. If possible, try to improve your credit score as much as possible before applying for a home mortgage.
- Decide on the lender: Not all lenders offer the same mortgage insurance rates and terms. Compare rates and terms from different lenders to find the best mortgage lender for you.
- Understand the terms: Read and understand the terms of your mortgage insurance policy. This will help you understand when and how you can cancel your insurance and what the penalties are for early cancellation.
- Budget accordingly: Factor the cost of mortgage insurance into your monthly budget. This will help you understand what you can afford and make sure you’re not overstretching your finances.
- Keep track of your equity: If you’re planning to cancel your mortgage insurance, keep an eye on your equity. As soon as you have enough equity in your home, you may be able to cancel your insurance and save money on your monthly mortgage payment.
With these factors in mind, you’re ready to find the best mortgage loan – with the best interest rate – for your new home purchase