The time had finally arrived—my husband and I had saved enough for a home down payment and we were off to the bank to get approved for our first mortgage. Talking to the loan officer we discussed term lengths, payment options, and the various fees included in our monthly payments. Principal and interest were clear, plus taxes and home insurance, but we were caught off guard by mortgage insurance.
This was the first time either of us had ever heard of insurance for a mortgage. It was a sobering realization that we had missed this key part of the process and that we would need to figure in yet another expense to our budget. Luckily, we learned that we could circumvent mortgage insurance and stay on budget.
Not everyone is so lucky. If you’re a first-time homebuyer doing the research to learn about the process of getting a home loan, here’s what you need to know about mortgage insurance.
Let’s clear up a common misconception right off the bat: Mortgage insurance does not protect homeowners. Rather, it diminishes the risk faced by mortgage lenders when borrowers have smaller home down payments, typically less than 20% of the purchase price.
“Mortgage insurance is not meant to protect you, but to protect the lender in case you default on the mortgage,” says Jeremy Schachter, branch manager at Fairway Independent Mortgage Corporation. In other words, you’re paying extra hard-earned cash that will ensure your lending institution gets paid if you go broke.
There’s more than one type of mortgage insurance, and the most common varieties include private mortgage insurance (PMI) on conventional loans and mortgage insurance premiums on FHA loans. Some types are paid upfront, while others are added as a fee on your monthly mortgage payment.
Don’t confuse it with other types of insurance you’ll encounter when buying a home. For example, title insurance is usually required to protect you from claims—legitimate or otherwise—against your home. Then there is mortgage protection insurance that is designed to protect borrowers, and of course everyday homeowners’ insurance that protects you in case of damage to the property.
So should you wait to buy a home until you’ve saved up enough money to afford a 20% down payment? Ultimately the choice depends on your financial goals, but the big advantage of mortgage insurance is that it can help people with smaller down payment amounts to qualify for a loan that they might not otherwise be able to afford.
Consider this example from Dr. Annie Cole, Ed.D. and founder of Money Essentials for Women: A $500,000 home purchase with 20% down ($100,000) and a 30-year loan at 7% interest, which amounts to a monthly payment of $3,056 with no PMI.
“If you were to buy a $500,000 home with a 10% down payment instead ($50,000), your monthly payment would be $3,389 with no PMI,” says Cole. “PMI for this mortgage, with excellent credit (760+), would be an extra $173 a month, bringing your total monthly payment to $3,562.” That’s a difference of $506 a month, or $6,072 a year.
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Now let’s say that you decide to save up more for a down payment and three years later you’re ready to buy a similar $500,000 home. The home has gone up 3% in price every year, and it now costs $546,363. With 20% down (now $109,272), your monthly payment without PMI will be $3,389.
“In the long run, PMI is just a small fraction of the cost to consider when buying a home,” says Cole. “And, it can be dropped the moment you own 80% of the home.”
Let’s not put the cart before the horse here—the main factor that determines what mortgage insurance you’re saddled with is the mortgage itself. Thankfully, there are several loan types where the insurance isn’t a requirement, but depending on your circumstances you may elect to purchase it anyway.
While most types of mortgage insurance generally do the same thing, they come in several different forms and go by different names depending on the type of loan you have. Let’s dive into the details:
The majority of homebuyers will take out a conventional loan and receive information on private mortgage insurance.
“[PMI] is required on all conventional loans with less than 20% down,” says Schachter. “Premiums are calculated based on your credit scores, the occupancy of the home, how much you are putting down, and your debt to income ratio.”
PMI is required with down payments below 20% because, as a borrower, you have less equity in the home. As a result, lenders feel you may have a greater chance of defaulting on your loan. PMI protects your lender in case of an emergency.
With conventional loans, private mortgage insurance is generally paid monthly as a part of your mortgage payment. However, some lenders may allow you to pay some or all of the premium in advance, which can lower your monthly payments. Schachter recommends asking your lender if they can shop around for policies that will get you the best rates.
If your credit score is too low for a conventional loan, you may qualify for a mortgage through the Federal Housing Administration (FHA). Due to a higher risk of default on these loans, the FHA requires all borrowers to pay two types of mortgage insurance premiums (MIPs): upfront and annual.
All FHA loans have an upfront MIP of 1.75% of the loan amount, followed by an annual payment of anywhere from 0.80% to 1.05% of the loan amount depending on the total principal and down payment size.
If you put at least 10% down when you bought your home, you’ll only have to pay the MIP for 11 years. However, for a down payment lower than 10%, you’ll pay it for the entire loan term.
While conventional and FHA loans cover the vast majority of homebuyers, there are still a few other types of mortgages available. Two of the most common are:
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VA loans: Though it’s not technically referred to as mortgage insurance, loans backed by the Department of Veterans Affairs require a funding fee to help lower the cost of VA loans and reduce risk for lenders. You can either pay your funding fee upfront at the time of closing or finance it into your loan, but keep in mind that financing it into your loan is more expensive since you’ll pay interest on it. The VA does waive this funding fee for qualified borrowers.
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USDA loans: Similar to FHA loans, USDA loans require both an upfront and annual payment to help reduce the cost and risk associated with them. USDA loans require an upfront guarantee fee of 1.00% of the loan amount and an annual guarantee fee of 0.25% of the loan amount.
USDA loan guarantee fees are required for the entire loan term, regardless of your down payment size.
Mortgage protection insurance can provide peace of mind and financial relief to your family if you pass away or become disabled. However, it’s not necessarily worth it if you have sufficient life insurance.
The proceeds of your life insurance can be used for any purpose, including paying off your mortgage. Life insurance is also more flexible, able to be used for any expense, while mortgage protection insurance can only be used for your mortgage. However, it often requires a medical exam to qualify for a policy. If you’re in poor health, you may be denied—or be required to pay a cost-prohibitive price.
Mortgage protection insurance, on the other hand, has guaranteed approval and doesn’t require a medical exam. Additionally, mortgage protection insurance often comes with disability protection, which term life insurance doesn’t.
Dennis Shirshikov, Professor of Finance, Economics, and Accounting at the City University of New York, says that the biggest misconception is that mortgage insurance is permanent. “Many borrowers believe that once they start paying, they’re locked into it for the life of the loan,” he says. “This isn’t true for most conventional loans.”
In fact, once you’ve established sufficient equity in your home, there are two ways to remove PMI from your mortgage:
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Wait for automatic cancellation: Your PMI will automatically be removed from your loan when you’re scheduled to reach 78% loan-to-value ratio (LTV). You won’t have to do anything for it to be removed, and it won’t cost you any additional money.
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Request to have it removed earlier: Your lender can remove your PMI as soon as you’ve reached 80% LTV, but you have to request that they do so. In some cases, your lender may require you to pay for an appraisal to prove your loan balance has reached 80% LTV.
Many borrowers choose to simply wait for their PMI to automatically fall off. But in some cases, it may be worth requesting to have it removed earlier, even if you have the added cost of an appraisal. For example, you may ask to have PMI removed early if your home value has increased significantly since you closed on your mortgage or if you’ve been making extra payments on your principal.
Erin Gobler contributed to this article.
This story was originally featured on Fortune.com
