Insurance. We get it for our cars. We get it for our health. We get it for our homes. Why? For peace of mind. Having insurance helps us sleep a little better and worry a little less about unexpected mishaps in life. We pay our premiums each month so that if something does happen, we can file a claim, take care of the issue and get on with our lives.
So, let’s talk about mortgage insurance. Following the above thinking, it would be easy to think that the point of mortgage insurance is to protect your mortgage in the event you can’t make payments. Unfortunately, that isn’t the case with mortgage insurance.
Mortgage insurance protects your lender if you can’t make mortgage payments.
When your lender loans you the money to buy a house, they place a lien against the property in the event you stop making payments. They can then legally take the property to make up for the unpaid loan balance if you default. That’s called foreclosure, and lenders don’t like to pursue foreclosure because it’s costly and time-consuming.
When they give you the loan, they anticipate that you would be making payments for the entire term of your loan. However, sometimes things happen and you can’t make payments. Lenders take a risk when they loan money. One of their biggest fears is that your home won’t be worth enough to cover the outstanding balance if they foreclose. One of the ways they get some peace of mind for themselves is mortgage insurance.
Mortgage insurance works like regular insurance in that there are monthly premiums paid to an insurance company and then when something happens, your lender can file a claim to recoup some of the cost of proceeding with a foreclosure.
When you apply for a conventional mortgage loan, the lender looks at a few things to determine if they need mortgage insurance. It’s not an automatic thing for all loans. First, they look at how much your property is worth versus how much you want to borrow versus how much of a down payment you are able to make. Comparing the value versus loan amount is called loan-to-value, and it represents as a percentage. This percentage is what determines if you will need mortgage insurance or not.
In most cases, any loan-to-value more than 80% is going to require private mortgage insurance for a conventional loan program.
Let’s say you want to borrow $95,000 for a house that, for simplicity sake, costs $100,000. This would put you at exactly 95% loan-to-value. This is very risky for the lender. If they had to resell the property as a result of foreclosure, they may not be able to get all of their money back. In this case, they would advise you that the loan needs private mortgage insurance.
Your down payment reduces the amount you need to borrow and the likelihood that you’ll need mortgage insurance. This is why it’s optimal to put at least 20% down. The further away from 100% loan-to-value you can get, the better off you are when it comes to needing private mortgage insurance.
Your credit score may also have an impact on the overall need for private mortgage insurance as well. Credit scores are an indicator of potential risk.
Once it’s determined that you need private mortgage insurance (PMI), an insurance provider is contacted by the lender and a policy is created, just like with life insurance. PMI companies have set rates based on loan-to-value and credit score. They also take into consideration borrower default rates, which they get from agencies like Fannie Mae and Freddie Mac.
Here’s a rough idea of how much you might pay for private mortgage insurance, based on a credit score of 740-759.
The PMI amount is added to the principal, interest, real estate taxes, and homeowners insurance to make up your total monthly mortgage payment.
If you do not take out a high risk loan, you may be able to cancel your PMI once your loan-to-value reaches 80% or lower.
The Homeowners Protection Act requires lenders to remove PMI automatically once a non high-risk loan reaches 78% loan-to-value.
You’ll receive a notice from your lender when this is going to happen. If you’re in a position to make additional mortgage payments each year, it will help you get to this a bit sooner. MI cancellation is usually setup contingent upon a certain amount of payments made and balance reduction, not just increase in property value. MI companies typically want you to pay the premium for a certain amount of time.
If you got your mortgage loan after January 1, 2007, you may also be able to deduct PMI when you file your taxes. Check with your tax professional about that one because this could change from year to year.
If you’re getting a loan that’s backed by the Federal Housing Administration (FHA), mortgage insurance is handled a little differently. The premium is paid directly to FHA and it’s required for all FHA loans, regardless of your credit score or down payment. FHA mortgage insurance includes an upfront premium which is included in your closing costs and a monthly premium, which is added to the principal, interest, real estate taxes, and homeowners insurance that make up your mortgage payment.
It still works the same as private mortgage insurance and protects your lender in the event you stop making payments on your mortgage loan.
For FHA, if you cannot afford the upfront premium, you can include that in your loan, but you’ll still have monthly premiums. The rates for FHA insurance are based on your term and down payment. Talk to your lender about what the current rates are for FHA loans.
Unless you got your FHA mortgage before June 3, 2013, FHA mortgage insurance does not have an automatic cancellation once you reach 78% loan-to-value.
As with any insurance, we all hope we don’t need it, but it’s one way to have peace of mind. If you have any questions or concerns about mortgage insurance, talk to your lender.