If you’re shopping for a home, you may have heard that putting out a 20% down payment is standard practice. But what if you can’t afford a 20% down payment? In cases like this, the lender may require you to get mortgage insurance.
5 Types of Mortgage Insurance
- Lender-Paid Mortgage Insurance
- Single-Premium Mortgage Insurance
- Split-Premium Mortgage Insurance
- FHA Mortgage Insurance Premium (MIP)
- Borrower-Paid Mortgage Insurance
Before discussing mortgage insurance, it’s helpful to briefly review what insurance is supposed to do in general. Insurance is a contractual relationship between the insurer and the insured, who may also be called a policyholder or subscriber. The policyholder pays the insurance company premiums for a privilege called coverage. This coverage means that if a specific event happens, the insurance company will provide a payment to defray the extent of the damage done by said hazard.
For most types of insurance, you or your dependents are the recipients of this lump sum payment, because the insurance policy is protecting you, your family, or your personal property. In the case of mortgage insurance, however, you are not the party that the insurance company is protecting. The purpose of mortgage insurance is to protect the lender.
What Is Mortgage Insurance and How Does It Work?
Any time a bank lends someone money, it is taking a risk that the money won’t be paid back. A home loan is a significant amount of money. Banks need to mitigate their credit risk with every single interaction. To mitigate this credit risk, they will first look at your credit history, employment, and other financial information. If the bank or mortgage lender believes you are safe enough to lend to, they can extend a home loan.
However, there are still significant risks for the bank moving forward. What happens if you lose your job? What happens if someone in the family dies and a significant portion of the income stream dries up? What happens if there is a divorce? Any number of things could happen that could put repayment of the home loan into jeopardy.
For these reasons, banks want you, the homeowner, to be invested in your home. A homeowner with at least a 20% investment in their home presents a significantly smaller amount of credit risk.
The relationship between the mortgage loan and the home’s assessed value is called the loan to value (LTV) ratio. Take the above example: If the homebuyer put forth $40,000 to purchase a $200,000 home, this means that the mortgage would need to be $160,000. The mortgage divided by the home value comes out to 80%, which is a decent LTV ratio. Without a 20% down payment, the loan becomes significantly riskier. However, it is still possible for the homebuyer to secure a mortgage if they get private mortgage insurance or PMI.
Homestead Laws / Homestead Exemptions
Another reason banks need buyers to put down 20% is because this amount prevents the homeowner from exercising Homestead Laws or Homestead Exemptions. These laws vary by state, but they can prevent a primary personal residence from being forced into a sale by the creditor. However, if the homeowner has an amount of equity in the home above a certain threshold, the creditor can force a short sale to recoup their losses.
Equity is essentially how much of the mortgage the homeowner has paid off, or how much of the home they actually own. While these amounts range from $5,000 in Kentucky to $600,000 in California, a 20% down payment is going to make it easier in most states for banks to force a sale if you can’t repay the loan.
Ultimately, however, a homestead exemption will not prevent foreclosure. Unlike a private real estate investor who provided a hard money loan and would be interested in the property, banks are not interested in becoming the new owner of your property. Banks typically sell the property rather than pay expenses to maintain it.
5 Types of Mortgage Insurance
If you cannot afford a 20% down payment, you are typically required to protect the loan with mortgage insurance. This is a type of insurance that will pay out to the bank if you default on the loan. In most cases, they do not cover the entire value of the property, so the bank will still be looking at a loss. However, their loss will be significantly less, so the loan becomes less risky for the lender.
1. Lender-Paid Mortgage Insurance
Lender paid mortgage interest or LPMI is somewhat misleading because you will still be paying the premiums. However, these payments will be bundled into the loan, just like some other expenses such as the cost of loan origination. The downside to lender-paid mortgage insurance is that because the insurance is wrapped up in the loan by the lender, you will not be able to cancel it or have it canceled once you drop the LTV ratio below 80%.
The upside of this type of mortgage insurance is that the monthly premium, bundled as it is into the monthly mortgage payment, may actually be lower than it would be if you were paying the insurance yourself. This is in part because the insurance is wrapped up in the loan, which will be repaid over 15 or 30 years, depending on what type of mortgage you obtained. Even with the best mortgage lenders, the only way to eliminate lender-paid mortgage insurance is to refinance the loan.
2. Single-Premium Mortgage Insurance
Single-premium mortgage insurance (SPMI), also called single-payment mortgage insurance, involves paying for all of your PMI up front in one lump sum of cash. This cost can be built into the closing costs or wrapped up in the mortgage so you pay it off over time. The downside is that if you sell your home or refinance it, you won’t get the premium back.
Another downside is that if you don’t have enough money to put down a 20% down payment, you probably won’t have enough to make a large insurance payment. However, as mentioned, it can be built into the loan itself. Another potential option is that the home seller can pay the single premium for you, and that can become part of negotiating the home price.
3. Split-Premium Mortgage Insurance
The split premium is a combination of borrower-paid mortgage insurance and single-payment mortgage insurance. This means paying part of the premium up front and the rest on a monthly basis. If you don’t have the money to pay up front and you don’t have the income to pay a higher premium every month, this can be a nice compromise that makes financing a home possible.
You can negotiate with the seller to pay the upfront portion and have that rolled into your mortgage. Unlike the single-payment premium, the split-premium may be partially refundable, as you are not paying it all up front at once.
4. FHA Mortgage Insurance Premium (MIP)
If you are a potential homebuyer who cannot afford a standard down payment, the Federal Housing Administration will help you out, as long as you can put down 3.5%.
The FHA serves as a mortgage insurer so that a mortgage servicer is willing to extend them to such borrowers. Higher LTV ratios are risky for lenders, but if banks were unwilling to offer loans to these types of borrowers, the housing market might stagnate. Borrowers obtaining an FHA loan will need to pay mortgage insurance premiums (MIP).
PMI vs MIP
It’s important to differentiate between PMI and MIP since they have the same letters and sound similar. PMI is private mortgage insurance. It’s sold by a financial institution like an insurance company underwriting for a conventional mortgage. A conventional loan is one offered to consumers without backing from the federal government. By contrast, MIP refers to mortgage insurance premiums, which are specifically related to government-backed loans.
This type of mortgage protection insurance has a few other key differences. The homebuyer will have to make part of the payment up front. This payment is often 1.75% of the value of the home.
By contrast, mortgage protection for a conventional loan does not require an upfront payment, although your mortgage servicer may facilitate that if it’s your preference and they offer single-premium. Even after paying the 1.75% upfront fee, you will still need to make a monthly payment for your MIP. MIP payments range from 0.45% to 1.15% of the loan amount, which is slightly lower overall than those of a PMI premium.
Unlike a PMI premium, which can disappear after you have surpassed that 20% home equity, you cannot get rid of MIP if you put less than 10% – unless you refinance the loan. If you put down more than 10%, you will still have to keep the MIP for 11 years. If you’re wondering why someone putting down more than 10% would need an FHA loan, you can still technically get an FHA loan no matter how big your down payment is.
5. Borrower-Paid Mortgage Insurance
Borrower-paid mortgage insurance (BPMI) is the most common form of PMI. This means that you, the borrower, will make the insurance premium payment, usually as an additional monthly fee tacked on to your mortgage payment. You can get your BPMI canceled when you have 22% equity in your home, surpassing the initially desired 20% equity of the bank’s preferred down payment amount. This might happen sooner than you think if your home value appreciates.
Remember that the LTV is calculated by dividing the mortgage amount by the property value. If the value goes up, that means the LTV goes down, which means less credit risk for the bank. You can be proactive and present a home appraisal, broker’s price opinion (BPO), or even use an automated valuation model (AVM) to initiate this conversation with the bank.
How Much Is Mortgage Insurance?
The cost of mortgage insurance depends on several factors, including your loan terms (15 or 30 years, for example), the type of mortgage you choose, the interest rate of your mortgage (fixed or adjustable), your down payment, your credit score, and how much coverage the lender needs.
Estimates for PMI range from 0.55% to 2.25% of the original loan amount per annum. For example, if you purchase a $200,000 home, you are looking at an annual cost ranging from $1,100 to $4,500 per year. If you’re making monthly payments, that’s $91 to $375.
In many cases, the insurance will be bundled into your monthly mortgage payment. This is why many mortgage loans have what are called PITI payments, which stands for premium, interest, taxes, and insurance. PITI payments also include homeowners insurance, which is insurance for the property itself. Remember that the lender does not want you to walk away from the loan or the property itself. Nor do they want to foreclose on and collect a damaged property. For these reasons, most lenders will also require you to get home insurance for as long as you’re paying the mortgage.
There are many kinds of mortgage insurance. Unlike most insurance, which protects you, your family, and your home, mortgage insurance is designed to protect the mortgage lender. Its costs and other impacts on your mortgage and home buying ability are something you should discuss with a potential loan officer when you’re looking at how to get a mortgage loan.
