Mortgage insurance

Mortgage Insurance is a money term you need to understand. Here’s what it means.

What is mortgage insurance?

Mortgage insurance is a product that insures a mortgage in case the borrower defaults. Homeowners who pay a down payment of less than 20 percent are required to pay mortgage insurance. That means it is frequently an added cost to loans for lower-income people.

Deeper definition

Certain conventional loans offer people with fewer financial resources the opportunity to buy a home with a much lower down payment. Because these home buyers are a higher risk than those with higher income and better credit, these borrowers must pay mortgage insurance to protect the lender in case they default. The U.S. government also backs some loans for lower-income people, through agencies like the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and the Department of Agriculture (USDA).

The cost of the premium is determined by the size of the down payment, the borrower’s credit score, and the cost of the home. Mortgage insurance usually comes out to around 0.2 to 1.5 percent of the principal. For conventional loans, the borrower pays private mortgage insurance (PMI), and the premium is paid to the lender; for government-backed loans, premiums are paid to the respective agency. Mortgage insurance can be paid each month along with the regular mortgage payment as a single payment.

Many people also pay a one-time fee at closing, which for loans backed by the FHA is called an up-front mortgage insurance premium (UFMIP) and for VA and USDA loans is called a funding fee. This fee varies between 1 percent and 3.30 percent of the loan amount, but it can be rolled into the mortgage payments if necessary.

The lender splits the amount of the annual premium over 12 months to determine how much to take out for monthly payments. A homeowner may also have the option to pay the premium annually in a lump sum called single-premium mortgage insurance, which could qualify the borrower for a larger loan amount as she won’t need to pay mortgage premiums monthly, or as a combination of up-front and monthly fees.

For commercial mortgage insurance, once the borrower has achieved 20 percent equity on her home, she can request that the lender discontinue mortgage insurance. The lender is also required to discontinue it without any action on the part of of the borrower when the principal balance hits 78 percent of the home’s original value. The borrower can also refinance her mortgage to get out of paying mortgage insurance.

Use Bankrate’s calculator to figure out how much house you can afford to buy.

Mortgage insurance example

Dana takes out a 30-year mortgage to purchase a home. The appraiser valued the home at $278,000 and her lender approved her for a $269,000 mortgage. That means her down payment of $9,000 is far lower than the 20 percent down payment she’d need to avoid paying PMI. However, because she has a very good credit score, she’ll probably only have to pay between $200 and $250 each month in PMI on top of her principal and interest payments.

More From Bankrate