Understanding Mortgage Insurance
The biggest hurdle to owning a home for most home-buyers is the down payment. For a majority of loans, the minimum down payment is 20% of the purchase price. The down payment serves as evidence to lenders that you are financially prepared to take on mortgage debt. If you don’t have 20% to put down on a home, you may be required to pay mortgage insurance. Many homeowners are paying it while others try to avoid it. So what is mortgage insurance and why are you having to pay it?
There are several types of mortgage insurance. On the conventional loan side, it is called private mortgage insurance (PMI) while on the FHA side, it is known as a mortgage insurance premium (MIP) since they have a different insurance structure. Mortgage insurance is paid for by the homeowner, but is used to protect the lender if the loan should go into foreclosure.
Private Mortgage Insurance
If you have a conventional loan and are short of the 20% of a home’s purchase price required down payment, your lender will arrange for PMI with a private company. These strict underwriting loan guidelines are set by Freddie Mac, Freddie Mae, and most investors in conventional loans. PMI rates are varied and are dependent on down payment amount and credit score. It is paid monthly with little to no initial payment required at closing.
PMI is expensive but can eventually be removed under several conditions:
- Once you have at least 20% equity in your home, you can contact your lender and ask to cancel. When you have paid down the mortgage balance to 78% of the home’s original appraised value, the lender is required to cancel PMI.
- Refinance your mortgage if the value of your home has increased enough to meet the 20% equity threshold.
- Obtain a new appraisal to see if you meet the 20% equity threshold.
- Prepaying on your loan will lower your loan balance quicker.
- Upgrading your home by adding a room or a pool can increase your home’s market value. Your lender can then use this new value to recalculate your loan-to-value ratio.
Mortgage Insurance Premium
FHA-insured loans work a bit different than conventional loans. FHA loans have a minimum down payment requirement of only 3.5% of the home’s purchase price. Therefore, MIP is required for all FHA loans and lasts for the life of the loan. MIP rates are fixed and are not dependent on credit score, with a slightly higher rate for those with less than 5% down payment. MIP has an upfront portion to be paid at closing (can be rolled into your mortgage if you are short on cash) and a portion that is paid in 12 installments per year which is included in your mortgage payment. For new home buyers with an FHA loan on or after January 2015, the current annual MIP rate is 0.85%, assuming a 30-year fixed rate FHA mortgage not exceeding $625,500 with 3.5% down payment.