If you have purchased a home in the past, or you are contemplating doing so now, you’ve probably heard of the term mortgage insurance. That’s because it is common in the industry, in that it is required any time you get a mortgage on a property either with a minimum down payment or with very little equity on a refinance.
What Is Mortgage Insurance
Mortgage insurance, commonly known as “PMI” – for private mortgage insurance – is a type of insurance obtained in connection with the creation of certain mortgages.
It’s commonly required on mortgage loans that are considered to be high risk. That is usually determined as loans in which the borrower is making a down payment of less than 20% of the purchase price on the property, or has less than 20% in equity in the case of a mortgage refinance.
Mortgage insurance is paid for by the borrower on the mortgage, but the beneficiary is the lender. There is some confusion in this regard due to mortgage life insurance, but that has nothing to do with mortgage insurance.
Mortgage life insurance is an actual life insurance policy covering the balance of the mortgage that will be payable to your beneficiaries in the event of your death to completely pay off the mortgage. That will leave your loved ones with a mortgage-free home, but it is not what we’re talking about here.
Why Do Lenders Require Mortgage Insurance?
The short answer is that there are certain loans that mortgage lenders would not make if they did not charge mortgage insurance. That’s because it protects the lender in the event of default on the loan.
It does this by ensuring that the lender will receive at least part of the mortgage balance if you as the borrower default on the mortgage.
Mortgage insurance doesn’t actually cover the entire balance of your mortgage. It is instead used to lower the effective loan-to-value ratio (LTV) of the mortgage to a more acceptable level. For example, if a lender requires “30% coverage” on a mortgage that has an LTV of 95% (5% down payment), the insurance coverage will lower the effective LTV by approximately 27%, making it a 68% loan.
By reducing the effective LTV on the loan, the lender has more protection in the event of default. With 68% exposure, the lender should theoretically have plenty of equity in the property to cover the cost of its disposition, as well as legal costs related to the foreclosure.
When is Mortgage Insurance NOT Required?
There are generally three situations in which mortgage insurance is not required in order to get a mortgage loan:
- You make a down payment equal to 20% or more of the purchase price of the home that you are buying, or
- You are refinancing your home and will have at least 20% equity in the property after taking the new mortgage, or
- You use a second mortgage or home equity line of credit (HELOC) as part of the down payment. A typical scenario is an “80-10-10”, in which the first mortgage is equal to 80% of the purchase price, there is a 10% second mortgage or HELOC, and you make a downpayment of 10% for the balance.
Notice that in each scenario, the lender is providing a loan of not more than 80% of the value of the property. Any time the mortgage lender’s loan exceeds 80% of the value of the property, mortgage insurance will be required.
How Much Does Mortgage Insurance Cost?
As noted earlier, you as the borrower will be responsible for making the payments to cover the premium on the required mortgage insurance. This isn’t a separate charge. Instead, the premium is calculated on a monthly basis and is included in your basic mortgage payment along with the principal, interest, property taxes, and homeowners insurance.
The cost of the premium works on a sliding scale. The higher the LTV, from 80.1% to 97%, the higher the premium will be. But the premium is also determined by other factors such as your credit score, the term of the loan, and whether or not the loan is fixed rate or adjustable (ARM).
Let’s say that you apply for a 30-year fixed rate mortgage for $250,000. The LTV is 95% of the value of the home, and you have a credit score of between 700 and 719. Based on those parameters, your annual mortgage insurance premium rate will be 0.87% of the mortgage amount.
With a factor of 0.87 applied to a $250,000 mortgage, your annual mortgage insurance premium will be $2,175. That works out to be a monthly premium of $181.25, that will be included in your monthly mortgage payment.
Given the cost of mortgage insurance, it’s easy to see why people want to get rid of it as soon as they can.
When and How You Can Get Rid of Mortgage Insurance
While it wasn’t always the case, your ability to eliminate mortgage insurance is now a legal requirement. That is the result of a law known as the Homeowner’s Protection Act of 1998.
Under that law, mortgage insurance can be removed from a loan when one of the following takes place:
- The mortgage amortizes down to 78% of the original property value, at which time it will be removed automatically by the lender.
- When at least half of the loan term has passed; for example, when 15 years have passed on a 30-year mortgage (even if the loan exceeds 78% of the original property value).
- You pay down the mortgage to the point where it is no more than 80% of the original value of the home.
- When the value of the home rises to the point where the outstanding mortgage balance is paid down to not more than 80% of the home’s current value.
There are several additional requirements under scenarios #3 and #4 above, including:
- You must request PMI removal from the lender in writing.
- You must have a good payment history and be current on your payments.
- The lender may require you to certify that there are no junior liens, such as a second mortgage or home equity line of credit on the property.
- The lender may require you to provide evidence, such as an appraisal, that the value of your property has not declined below the value of the home when you first bought it (Scenario #3), or that the value has risen to the point where the outstanding mortgage balance is no more than 80% of the current value of the home.
If you believe that the loan has reached the point where it’s time to drop the mortgage insurance, you should contact your lender and find out what the process involves. Make sure that you know the specifics of what is required and never take steps based on assumptions or third-party information.
So there you have the basics of mortgage insurance. It’s expensive, and you’d rather not have it. But in the end, it actually enables you to get the mortgage that you need to purchase a home and that you might not qualify for without the insurance coverage.