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When you buy a home, you probably expect to shop around for the best mortgage rates, take out a mortgage and make a down payment. But there’s another step you might need to take. If your down payment is less than 20 percent of your home’s purchase price or you’re taking out a particular mortgage (such as an FHA loan), you might also need to buy mortgage insurance. For lenders, these are higher-risk lending situations, so they require mortgage insurance to protect their interests.
Keep reading to find out what mortgage insurance is, what it covers and how it works.
What is mortgage insurance and what does it cover?
Mortgage insurance is an insurance policy that protects the mortgage lender, but the borrower is the one who pays for it. With mortgage insurance, the lender or titleholder is covered in case you are unable to pay back the mortgage.
Mortgage insurance covers if you default on payments, fail to meet contractual obligations, pass away or wind up in any other situation that prevents you from completely repaying your mortgage.
How mortgage insurance works
In general, you’ll need to pay for mortgage loan insurance if you put down less than 20 percent on a home purchase. This is because you have less invested in the home upfront, so the lender has taken on more risk in giving you a mortgage. How much you’ll pay depends on the type of mortgage loan you have and other factors.
Even with mortgage insurance, you’re still responsible for the loan. If you fall behind on or stop making payments, you could lose your home to foreclosure. The mortgage insurance policy only protects your lender, not you.
How much does mortgage insurance cost?
The higher your down payment, the lower your mortgage insurance premium will be.
If you have an FHA loan, you’ll need a specific type of mortgage insurance, and you’ll pay a mortgage insurance premium, or MIP. Your upfront MIP is 1.75 percent of your loan amount, while your annual premium ranges between 0.45 percent and 1.05 percent. For a $350,000 loan, your upfront MIP premium would be $6,125. Your annual premium would fall between $1,575 and $3,675 (paid monthly with your mortgage).
USDA loans come with an upfront guarantee fee of up to 3.5 percent of your loan amount, as well as an annual fee that can be up to 0.5 percent of your loan amount. Using the $350,000 loan example, that would come out to a maximum of $12,250 upfront and $1,750 annually.
For VA loans, the funding fee will range from 1.25 percent to 3.3 percent, depending on your down payment amount and whether or not you’ve taken out a VA loan before. That comes out to $4,375 to $11,550 for a $350,000 loan.
How is mortgage insurance calculated?
Mortgage insurance is calculated based on loan amount, loan-to-value (LTV) ratio (in other words, your down payment amount) and other variables. The higher your down payment, the lower your mortgage insurance premium will be.
Pros and cons of mortgage insurance
It’s pretty clear how this coverage benefits the lender, but how does mortgage insurance work for the borrower? Here’s the main upside and downside for you as the borrower.
Pros of mortgage insurance
While mortgage loan insurance primarily benefits the lender, it does serve a purpose for the borrower because it allows you to get a mortgage with limited down payment savings. Putting down 20 percent can be challenging, especially with home values on the rise. By paying for mortgage insurance, you can still get a loan without needing a large down payment (assuming you qualify based on other eligibility parameters).
Cons of mortgage insurance
The downside of mortgage insurance: It’s an extra expense you wouldn’t otherwise have to pay. And if you’re getting an FHA loan, you’ll likely need to continue paying it for a while — at least 11 years and often for the entire life of the loan.
Types of mortgage insurance and other fees
The type of mortgage insurance you’ll need depends on several factors, including the kind of loan you have. Since mortgage insurance protects the lender, your lender chooses the insurer that provides the policy.
The various types of insurance on a mortgage include:
Private mortgage insurance (PMI)
PMI, or private mortgage insurance, is typically required if you’re obtaining a conventional loan with less than 20 percent down. This can include a 3 percent or 5 percent conventional loan or another type of low-down payment mortgage. Most borrowers pay PMI with their monthly mortgage payment. The cost of this insurance on a mortgage varies based on your credit score and loan-to-value (LTV) ratio.
FHA mortgage insurance premium
MIP is the mortgage insurance premium required for an FHA loan with less than 20 percent down. You’ll pay for this mortgage insurance upfront at closing, and also annually. The upfront MIP equals 1.75 percent of your mortgage, while the annual MIP ranges from 0.45 percent to 1.05 percent of your mortgage based on the amount you borrowed, LTV ratio and the length of the loan term (30 years or 15 years).
USDA guarantee fee
The USDA guarantee fee is one of the costs you’ll pay to obtain a USDA loan, which is only available to borrowers in designated rural areas and has no down payment requirement. You’ll pay the guarantee fee upfront and annually, with the upfront fee equal to a maximum of 3.5 percent of the loan and the annual fee equal to no more than 0.5 percent.
VA funding fee
VA loans also have no down payment requirement, but are available exclusively to service members, veterans and surviving spouses. While there is no mortgage insurance required for these loans, there is a funding fee that ranges from 1.25 percent to 3.3 percent of the loan, depending on whether you’re making a down payment (and the size of it, if so) and if this is your first time obtaining a VA loan. This funding fee doesn’t have to be paid for some exempt servicemembers, veterans and surviving spouses.
Mortgage insurance FAQ
If you have a conventional or FHA loan and you’re putting less than 20 percent of the home’s price down, you’ll be required to pay mortgage insurance. If you have a VA or USDA loan, you’ll also pay fees (though there are exceptions for some VA loan borrowers).
You can get rid of mortgage insurance in many ways, including paying down your loan, refinancing or requesting cancellation when you reach a certain percentage of equity in your home (20 percent for many lenders). Keep in mind: If you have an FHA loan and you put down less than 10 percent, you can’t get rid of the insurance unless you refinance to a different type of loan.
No. The itemized deduction for this cost has expired, so unless legislation renews it, you won’t be able to claim a tax perk for your mortgage insurance premiums.
Mortgage insurance protects the lender if you stop paying your mortgage. Homeowners insurance protects you if you experience a covered loss (e.g., your house burns down in a fire).
You can’t simply stop paying for the insurance policy, even if you’ve reached your loan type’s required equity for cancellation. Instead, you first need to work with your lender to get the mortgage insurance policy canceled and that cost removed from your monthly payments. However, by law, lenders must cancel PMI on conventional loans when you’ve reached a 78 percent LTV ratio.