Mortgage insurance: everything you need to know

Mortgage insurance is a financial product that indemnifies a lender in the event a default takes place on a mortgage loan. It does not provide coverage to the borrower of the loan who is required to purchase it as a condition to getting a mortgage.

How does mortgage insurance work?

Lenders usually make this type of insurance a requirement for borrowers whose equity in the property is under twenty percent - an example would be putting a $5,000 down payment on a $100,000 home. In this example, the buyer's equity is only five percent instead of the required twenty percent; therefore, he has to purchase mortgage insurance.

The need for mortgage insurance is borne about by studies and experiences of lenders with borrowers who have little or no equity at all in a loan agreement. Studies reveal that these types of borrowers are more likely to default on their loan repayments.  Mortgage insurance minimizes that risk as it allows the lender the opportunity to recover what they have lost in the defaulted mortgage.

The benefits of mortgage insurance

  • It provides many consumers who have limited funds an opportunity to own their own home. With mortgage insurance, they need not save or come up with the standard twenty percent down to be able to qualify for a home purchase mortgage.
  • For homeowners who are looking to get a refinance, mortgage insurance allows them to secure one without them having to meet the standard twenty percent homeowner's equity on the home.
  • To lenders, mortgage insurance gives them assurance that the mortgages they fund are protected, which in turn gives them confidence to produce more thereby expanding the opportunity of owning a home to many more consumers.

Private Mortgage Insurance versus FHA Mortgage Insurance Premium

In many cases, consumers are bound to come across these terms: PMI and MIP.

Private Mortgage Insurance is associated with conventional mortgages - home loans that meet the standards upheld by Fannie Mae and Freddie Mac.

On the other hand, Mortgage Insurance Premium is associated with Federal Housing Administration or FHA mortgages.

The basic idea of insurance protection behind PMI and MIP are the same. However, many consumers are not aware of the differences that make each one distinct from the other.

PMI

  • Minimum down payment on many PMI loans is five percent.
  • Can be availed of in a number of plan configurations as well as payment options.
  • Consumers who consider mortgages with PMI need not pay upfront the PMI premium.
  • Can be removed or canceled after the consumer reaches a certain loan-to-value level (eighty percent LTV) along with establishing a good payment history.
  • PMI loans are relatively more difficult to secure - underwriting requirements are stricter.
  • Even if a consumer gets qualified for a PMI mortgage, the PMI insurance company can still opt not to provide coverage on a particular loan. If it does, the loan will be denied.
  • If the borrower puts a twenty percent downpayment, he is not required to pay PMI.

FHA MIP

  • Minimum downpayment on FHA loans is 3.5 percent.
  • FHA MIP is made up of two types of mortgage insurance: one that is paid upfront during mortgage closing and another that is paid on a monthly basis.
  • Much easier to qualify for an FHA MIP loan because of less strict underwriting requirements.
  • Upfront MIP is a requirement on FHA loans.
  • MIP can only be canceled when the borrower has established seventy eight percent (78 percent LTV) equity on the home, AND the borrower has paid his monthly MIP premiums for five straight years.

How much mortgage insurance will cost you

PMI: The amount you will pay for PMI will be decided by the mortgage lender. Each lender would have its own set of criteria. Typically, the criteria would include the size of the downpayment, the borrower's credit rating, the type of loan, and the length of the loan term.

In general, the cost of PMI can be anywhere from 0.5 percent of the loan amount up to one percent. Hence, if the mortgage is $200,000 and the rate used is 1 percent, the cost of PMI would be $2,000 each year. The amount paid out per month would come down to  $166.66.

Applying PMI on a home that has the average national price of $230,000, the monthly mortgage insurance payments will be around $200 monthly.

FHA MIP: While PMI rates differ from one lender to another, FHA MIP rates are applied uniformly to all borrowers.

MIP rates are regularly updated. Starting last April 9, 2012, the upfront MIP rates on single-family FHA loans went up from one percent to 1.75 percent. This means on a $300,000 loan, the Upfront MIP would be $5,250.

The yearly MIP rates (which is paid every month) also increased from 1.15 percent to 1.25 percent for mortgages amounting to less than $625,500 and up to 1.5 percent on mortgages that are greater than that amount. Again, for a $300,000 mortgage, this would be equivalent to $3,750 per year or $312.5 per month.

Choosing a private mortgage insurance provider

Unlike other many forms of insurance, the borrower does not get to choose from what company he is going to purchase mortgage insurance. This is done by the mortgage lender, since they are the ones who will be indemnified in case of a default on the home loan.

So, if you are shopping around for a mortgage with PMI, choose one whose terms appeal to your best interest.

PMI Payment Options

Unlike FHA MIP, PMI on conventional loans come in different payment options. These options and their advantages and disadvantages are presented below:

  • Borrower Paid Monthly PMI

    Here, mortgage insurance is paid every month. Also, up front cost is commonly not required. The advantage of this type of BPMI is that the rate is almost the same for most lenders. Also, when payments reach seventy eight to eighty percent loan-to-value, the MI can be canceled. The disadvantage is that it is in many cases the most costly MI product.

  • Lender Paid PMI

    MI premiums are assumed by the lender. In return, the borrower gets a higher rate of interest. Advantages: most mortgage lenders offer this type of MI and no up-front expenses are involved. Also lower payments per month compared to BPMI. Downsides are: MI rates vary a lot from one mortgage provider to another. Also, cancellation of LPMI is not possible even when LTV reaches the seventy eight percent to eighty percent level. The higher rate remains throughout the loan term.

  • Single Premium PMI

    Lump dollar amounts are paid in this type of MI. The amount can be made part of the loan amount or paid during mortgage close. The benefit of this type of PMI is that will give you the cheapest payment per month compared to the rest. The downside is that it is not available with all lenders and that it requires an upfront payment or an additional amount to the loan principal.

  • Split PMI

    This has mixed features of Single PMI and Borrower Paid Monthly PMI - the borrower can opt for an upfront amount and a monthly amount. The larger the amount paid upfront, the smaller he will pay monthly. The benefit here is the flexibility afforded to the borrower. The downside is that an upfront payment would be required and this product is not widely available.

Options on how to avoid mortgage insurance

This section deals with avoiding PMI on a conventional mortgage. That is, you are in a situation where you do not have enough funds to avoid it (you can not meet the twenty percent downpayment).

In the recent past, many people took advantage of getting two mortgages --- for example if the purchase price of the home is $100,000, the first loan will cover $80,000 while the second loan will cover the downpayment of $20,000. In doing so they avoided PMI.

In today's economy this type of arrangement would be difficult to obtain because not many lenders offer second mortgages under this setup. In fact if you get a second mortgage, lenders would require that the total balance of both the first and second loan will not go beyond eighty percent of the value of the home.

This leaves you with one option: get a portfolio loan. This type of loan is offered under a lender's investment portfolio.  Loans like this are not traded in the secondary mortgage market and therefore not required to follow Freddie Mac and Fannie Mae standards. However, there could be downsides like difficulty in finding a lender who can offer you good terms. If you are thinking of getting one, compare the rates and the cost to you versus a PMI loan.

How to remove or cancel mortgage insurance

Removing PMI on a conventional mortgage

  • The Homeowner's Protection Act provides that when homeowner's equity reaches eighty percent of the home's purchase price, you can request for cancellation of PMI provided that your payments are updated and you have no late payments for the past thirty days on the date of the request or you have no late payments for sixty days during the last two year period.
  • The lender may require proof that the home's appraised value has not decreased and that there is no other lien (second mortgage) attached to the home.
  • The Act requires lenders to cancel PMI thirty days from the date you made the request to cancel.
  • If you think you have met the conditions necessary for a cancellation, call your lender for further details on the process.
  • Expect that you will be required to make a formal request and also a formal appraisal will be needed. In many cases, the homeowner bears the cost of the home appraisal.
  • Once you have sent your letter, await for the lender's reply.

Removing FHA MIP

  • Look for your mortgage amortization schedule along with the Truth in Lending or TIL statement. The statement will tell you when you can cancel MIP.
  • Get the original purchased price of the home and multiply by .78. The result is the target balance for MIP removal.
  • Look at the schedule of amortization and see where the target balance is.
  • From the amortization schedule, use the target balance amount and subtract this from your current balance. This will give you an idea as to how far or near you are from the seventy eight percent level.
  • Also, take note that you establish five full years of payments to be able to cancel MIP.
  • Get in touch with your lender once you meet the required level of equity and the 5-year record of payments.
  • Have the page that shows the present balance in the amortization schedule photocopied. You also need to do the same for the original appraisal and closing statements.
  • Write a formal request and mail this along with other proof to the lender.
  • Follow up until you get a reply.
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