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What Is Mortgage Insurance and How Does It Work?
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Mortgage insurance protects your lender if you can’t make your monthly payments. You’ll typically pay mortgage insurance premiums if you don’t make a big down payment or only qualify for government-backed home loan programs. Understanding how mortgage insurance works may help you avoid or reduce the premiums you pay during your loan term.
What is mortgage insurance?
Mortgage insurance is a type of insurance policy you’re required to buy to give your lender financial protection against losses if you’re unable to pay your mortgage. When you default on a mortgage and the lenders foreclose, they incur legal fees to process the foreclosure and expenses associated with remarketing and reselling the home. Mortgage insurance helps cover these costs and allows lenders to make low-down-payment loans they might not want to take the risk on otherwise.
How does mortgage insurance work?
There are three different ways that mortgage insurance works: as insurance from a private company, government insurance or a government guarantee. How it works depends on the loan program you’re applying for. Here’s a brief overview:
Private mortgage insurance (PMI)
If you apply for a conventional loan with less than a 20% down payment, your lender will contract with a private mortgage insurance (PMI) company to offer different mortgage insurance options. The premiums will vary based on your down payment, credit score and several other factors. They can be paid monthly, in a lump sum or added to your interest rate.
Government mortgage insurance
The Federal Housing Administration (FHA) insures loans with down payments as low as 3.5% by charging two types of FHA mortgage insurance premiums. The first is an upfront mortgage insurance premium (UFMIP) that is typically added to the loan amount. The second is the annual mortgage insurance premium (MIP), which varies based on your down payment and home’s location. MIP is charged yearly, but is divided by 12 and added to your monthly mortgage payment.
Government guarantees: VA and USDA loans
Lenders that make loans backed by the U.S. Department of Veterans Affairs (VA) are protected by a VA guarantee, which covers lenders if a borrower defaults on a VA loan. Only eligible military borrowers can apply for a VA loan, and there’s no monthly or lump-sum mortgage insurance. However, most VA borrowers must pay a funding fee that ranges from 0.5% to 3.6% of their loan amount and is charged to offset the taxpayer burden related to VA loans. Military veterans with a service-related disability may qualify for a fee exemption.
Loans backed by the U.S. Department of Agriculture (USDA) are also “guaranteed” by the government, but they work more like FHA mortgage insurance. Designed for low- to moderate-income borrowers to purchase homes in rural areas, USDA loans require two types of guarantee fees. The first is a lump-sum amount that is usually rolled into your loan amount. The other is an annual guarantee fee that’s divided by 12 and added to the monthly mortgage payment.
Why is mortgage insurance important?
Mortgage insurance is important for a number of reasons. Because of mortgage insurance:
You can buy a home with a low down payment.Lenders wouldn’t be willing to take the risk on low- or no-down-payment loans without mortgage insurance. In many cases, that means you’d need at least a 20% down payment to buy a home, which would limit the number of people who could afford to purchase homes.
You can qualify for low-down-payment loans with lower credit scores.The mortgage insurance and guarantee fees you pay on FHA, VA and USDA loans allow lenders to make no- and low-down-payment loans to borrowers with scores below the 620 conventional minimum, which opens up more buying opportunities for credit-challenged homebuyers.
How much does mortgage insurance cost?
The table below gives you a side-by-side look at the cost of different types of mortgage insurance you might pay for standard mortgage programs.
| Home loan program | Cost of mortgage insurance | Factors that affect your premium |
|---|---|---|
| Conventional | $30 to $70 per month for every $100,000 borrowed | Credit score Loan-to-value (LTV) ratio Occupancy Type of home being financed Number of borrowers Debt-to-income (DTI) ratio Loan term Fixed rate vs. adjustable rate Loan purpose |
| FHA | 1.75% UFMIP for most loans 0.45% to 1.05% MIP | LTV ratio Loan purpose Location of property Loan term |
| VA | 0.5% to 3.6% for most loans | Down payment amount Loan purpose How often home loan benefits have been used Service-related disability status |
| USDA | 1% upfront guarantee fee 0.35% annual guarantee fee | None |
THINGS YOU SHOULD KNOW
Your LTV ratio is one of the most important factors determining how much you’ll spend on mortgage insurance and funding fees for conventional, FHA or VA loans. Your LTV ratio is a measure of how much of your home’s value you borrow, and is directly related to your down payment. For example, a 97% LTV ratio means you’re making a 3% down payment. A higher down payment translates to a lower LTV ratio and reduces your mortgage insurance and funding fee expenses.
PMI vs. MIP: How to choose which is best for you
Most first-time homebuyers will take out a conventional or an FHA mortgage. While both programs offer low-down-payment options, the mortgage insurance may make or break your budget and your loan approval for a number of reasons we’ve covered in the table below.
| PMI is best if: | MIP is best if: |
|---|---|
| You can make a down payment of 5% or more | You can only afford a 3.5% down payment |
| You have a credit score above 680 | You have a credit score between 500 and 679 |
| You have a low DTI ratio | You have a high DTI ratio |
| You’re buying a second home | You’re buying a primary residence only |
How to avoid mortgage insurance
There are ways to completely eliminate different types of mortgage insurance.
Private mortgage insurance
- Make at least a 20% down payment. You can get a mortgage without PMI by making a down payment of at least 20%.
- Take out a piggyback loan. Rather than paying mortgage insurance, you can take out a home equity loan or home equity line of credit (HELOC) and “piggyback” it on top of your first mortgage. In most cases, you’ll need a 10% down payment for the 80-10-10 loan, which is the most common piggyback option. Here’s how it works:
- Borrow 80% of the home’s value as a first mortgage
- Borrow 10% of the home’s value as a home equity loan or HELOC
- Make a 10% down payment toward your home purchase
FHA mortgage insurance
- The only way to avoid FHA MIP and UFMIP is to choose a different loan program.
VA funding fee
- Apply for a VA disability waiver. Military veterans with a service-related disability may be eligible for a funding fee exemption. Find out if you’re exempt by obtaining your VA certificate of eligibility.
USDA guarantee fee
- The only way to avoid USDA guarantee fees is to choose a different loan program. There is no way to reduce the cost of them.
How to reduce mortgage insurance expenses
If you’re not able to avoid mortgage insurance, these steps may at least help you reduce the cost of mortgage insurance.
PMI
- Boost your credit scores. Your credit score plays a big role in your PMI costs; keeping low credit card balances and paying on time could mean big savings.
- Ask the seller to pay a lump-sum PMI premium. Consider using a seller concession to buy out your PMI costs with lump-sum PMI. You might end up needing cash for the other costs, but you’d have a lower monthly mortgage payment.
- Choose lender-paid mortgage insurance. Taking a higher interest rate so your lender pays your mortgage insurance upfront may keep your out-of-pocket costs low at the closing table. However, you’re stuck with the higher rate for the life of the loan.
- Check your home equity regularly. You can ask to cancel PMI once you’ve reached 20% equity. You might have to pay for a home appraisal, but it’s worth it if home prices are booming in your neighborhood.
- Buy a single-family home. You’ll get the lowest premium for a single-family home; condos, co-ops, multifamily and manufactured homes cost more.
- Keep your DTI ratio low. A DTI ratio higher than 45% usually comes with a higher PMI premium.
- Choose a shorter loan term and a fixed interest rate. You’ll shell out more PMI dollars for a term of 20 years or more, or if you get an adjustable-rate mortgage (ARM).
FHA UFMIP and MIP
- Make at least a 10% down payment. The annual MIP is slightly lower with at least a 10% down payment, and it will drop off your loan after 11 years.
- Choose a shorter loan term. If you can afford the payments of a 15-year mortgage term, you can reduce your monthly MIP premium.
- Refinance to a conventional loan as soon as you can. If you chose an FHA loan because your credit scores were low, refinance your FHA loan to a conventional mortgage as soon as your credit is in better shape to refinance and get rid of PMI costs.
- Ask the seller to pay the UFMIP. The FHA permits sellers to pay up to 6% of your sales price to cover FHA closing costs, including your UFMIP.
- Do an FHA streamline refinance. If you currently have an FHA loan, the FHA streamline refinance allows you to refi with reduced MIP costs. An added bonus: You don’t need income documents or an appraisal.
VA funding fees
- Make a bigger down payment. A down payment of 5% to 10% may save you thousands of dollars on the funding fee.
- Ask the seller to pay the funding fee. VA guidelines allow sellers to pay up to 4% of the sales price toward the buyer’s VA closing costs.
- Save your VA home benefits for your dream home. The VA funding fee is 2.3% of your loan amount the first time you use it, compared to 3.6% for every use thereafter. On a $300,000 loan, for example, you’ll save an extra $3,900 on the fee if you use your VA eligibility for the first time.
Frequently asked questions
Do I need mortgage insurance?
You’ll typically need to pay some type of mortgage insurance if you can’t make a 20% down payment on a conventional mortgage, or only qualify for government-backed loan programs.
What is the difference between homeowners insurance and PMI?
Homeowners insurance reimburses you for costs if you experience a loss like theft or damage to your home. PMI reimburses the lender for costs they incur if they have to foreclose on your home.
How long do you pay for PMI?
You’ll pay PMI until your loan is paid down to 78% of the original amount you borrowed. However, you may be able to remove PMI if you can prove you’ve built up 20% equity since purchasing your home.
Do you have to pay PMI on a conventional loan?
Yes, if you are buying a home with less than a 20% down payment. However, you may be able to avoid it with a piggyback loan.
Can you finance PMI?
Yes. The premium can be added to your interest rate if you choose “lender-paid mortgage insurance” (LPMI). The lender pays PMI on your behalf and you accept a higher interest rate in exchange.
Is title insurance the same as mortgage insurance?
No. Title insurance protects you from claims against your home from prior owners, such as tax liens or judgments. Most lenders require you to purchase a “lender’s title policy” if you’re getting a mortgage.
What is mortgage protection insurance?
More commonly called mortgage life insurance, some companies may offer this type of policy that pays off your mortgage if you unexpectedly die before your loan balance is paid in full. It’s never required by lenders and is an optional insurance product.