If you’ve ever tried to buy a home with a down payment of less than 20%, you’ve probably heard of mortgage insurance. This financial tool—mainly for lender protection—allows people to buy a home without making a large down payment.
Here, we’ll explore the ins and outs of mortgage insurance, including what it is, how it works, the different types available, who needs mortgage insurance and how it affects your monthly payments.
Mortgage insurance explained
Mortgage insurance is a type of insurance that protects lenders in the event that a borrower defaults on a mortgage loan. It is usually required for homebuyers who make a down payment of less than 20% of the total price of the home. There are several types of mortgage insurance offered by government and private agencies.
When a borrower takes out a mortgage at a discount of less than 20%, the lender may require the borrower to pay for the 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 payments can vary depending on:
- Loan type
- The size of the first batch
- The creditworthiness of the borrower
Depending on the type of mortgage credit insurance, you may be able to cancel your mortgage insurance once 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 – or can’t – spend 20% on a down payment, mortgage insurance is an excellent tool for you.
Lenders would be less likely to approve smaller down payment loans without mortgage insurance. This may 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 on your mortgage.
Is it required?
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 having mortgage insurance.
Some government-backed loan programs, such as FHA loans, require mortgage insurance built-in. Lenders usually finance this into the loan.
What are the types of mortgage insurance?
There are several types of mortgage insurance, each with its own unique characteristics and requirements. This section will discuss the four main types of mortgage insurance: private mortgage insurance (PMI), mortgage insurance premium (MIP), USDA guarantee charges, and VA financing charges.
Private Mortgage Insurance (PMI)
Private financial institutions can require a PMI for homebuyers who cannot make at least a 20% down payment. The cost of a PMI is usually added to the monthly mortgage payment and can range from 0.3% to 1.5% of the original loan amount annually. The exact cost of a PMI depends on a variety of factors, including your credit score.
You can usually cancel your PMI once enough equity has been built up in your home. This usually happens when you pay off your loan enough 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 paying monthly. This is known as LPMI (Lender Paid Mortgage Insurance), and it’s a way to avoid paying a monthly PMI.
Mortgage Insurance Premium (MIP)
MIP is required for Federal Housing Administration (FHA) loans. These loans are government-insured and are designed to help first-time and low-income homebuyers purchase a home.
MIP is usually more expensive than PMI. The cost of a MIP is usually added to the monthly mortgage payment, and can be substantial depending on the loan amount and down payment. Unlike a PMI, which you can cancel when you reach a certain level of equity in a home, a MIP is usually required for the life of the loan. This means that you will have to pay the MIP until you pay off the loan or refinance to a different type of loan.
If you’re considering refinancing, read our guide on the best mortgage refinancing options, and be sure to follow our mortgage refinancing steps checklist.
Along with your monthly mortgage payments, you will have to pay your MIP upfront at closing time. This one-time payment is usually 1.75% of the loan amount.
USDA guarantee fee
A USDA Escrow Fee is required for homebuyers looking to purchase a home in a rural area with a USDA loan. This type of loan is supported by the USDA and is designed to help low- and moderate-income homebuyers in rural areas. The government offers USDA loans with more credit and income requirements than traditional ones.
The USDA guarantee fee is also added to the loan amount, which ranges from 0.35% to 2.75%. Lenders may be able to offer lower security fees to lower income borrowers. But higher income borrowers will still have to pay higher fees.
Lenders use these fees to offset the costs associated with providing the loan and to ensure the long-term sustainability of the USDA loan program. Fees are usually paid in advance at the time of closing, but can be financed with a loan.
VA financing fee
A VA finance fee is required for homebuyers looking to purchase a home with a Department of Veterans Affairs (VA) backed loan. This type of mortgage insurance is available to veterans, active duty members, and spouses of service members — active or veterans. VA loans are offered by the government and have lower credit and income requirements than traditional loans. It also requires no down payment, making it an affordable option for veterans and service members.
The VA financing fee is added to the monthly loan installments and can range from 1.4% to 3.6% of the loan amount.
Advantages of mortgage insurance
It may seem like an added expense, but mortgage insurance has many advantages if you are 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 low down payment. For conventional loans, a 20% down payment is usually required. Given the current real estate market, this down payment can be quite substantial. But with mortgage insurance, you can drop as little as 3% and get the home you want.
cancellation: You may be able to cancel most types of mortgage insurance once you build up enough capital. This can add up to significant savings for you over the life of the loan.
Lenders Protection: Mortgage insurance protects lenders and allows them to continue making loans. Loan defaults happen, but this insurance allows lenders to maintain enough backing to continue making loans to you and other buyers.
Cons of mortgage insurance
Like any financial product, mortgage insurance also has its drawbacks. This section discusses some of the cons of mortgage insurance.
Additional cost: The main disadvantage of mortgage insurance is the 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 original loan amount annually. For some people, this extra cost can be a huge burden in the long run. Be sure to weigh the pros and cons and decide if you’d rather pay for a typical down payment or if you’d be better off paying a few hundred dollars more each month.
Not all types of mortgage insurance can be cancelled: If you’re considering getting your mortgage insurance canceled, know that some types of mortgage insurance, such as FHA mortgage insurance, may require the borrower to carry the insurance for the life of the loan regardless of equity.
How much do 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 credit score of the borrower. You can expect a small percentage of the total loan amount to be added to your monthly payments. Below are the expected costs for different types of mortgage insurance.
The cost of private mortgage insurance can vary, but is typically between 0.3% and 1.5% of the original loan amount annually.
On the other hand, the cost of a MIP is usually 0.5% to 5% of the original loan amount annually. There is also a one-time closing fee of approximately 1.75% of the loan amount.
For government-backed loans, the USDA guarantee fee is about 0.35% to 2.75%, and the VA financing fee is about 1.4% to 3.6%.
Not all mortgage insurances are permanent. Once you reach a certain level of equity, you can request that the mortgage insurance be removed. If your loan provides this feature, it can make buying a home more affordable than loans that don’t. If you are interested in this feature, look into traditional loans with PMI.
Your next steps
If you’re looking 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.
- Understanding Loan Types and Mortgage Insurance: Learn the differences between the types of insurance described in this guide to see which is best for you. Research the different loans offered by both private organizations and the government to find the one that best suits your needs. Finally, consider whether you need a conventional mortgage or a reverse mortgage. If you are considering getting a reverse mortgage, see our guide to the best mortgage providers.
- Check your credit score: Before you can apply for a low down payment loan, you will need to review your credit score. If possible, try to improve your credit score as much as possible before applying for a mortgage.
- Select Lender: Not all lenders offer the same rates and terms of mortgage insurance. Compare rates and terms from different lenders to find the best mortgage lender for you.
- Understand the terms and conditions: Read and understand the terms and conditions of your mortgage insurance policy. This will help you understand when and how you can cancel your insurance and the penalties 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 ensure that you are not stretching your cash.
- Watch your property rights: If you plan to get your mortgage insurance off, keep an eye on your equity. Once you have enough equity in your home, you may be able to cancel your insurance and save money on your monthly mortgage payments.
With these things in mind, you’re set to find the best mortgage—with the best interest rate—for your new home purchase.