What is mortgage insurance and why do I have to pay it?

This blog post has been migrated to my new blog, you can find it here: What is mortgage insurance and why do I have to pay it?

Let's start with the basics - what is mortgage insurance?

Many homeowners feel mortgage insurance is imposed on them by banks for no reason and they don't benefit from it in any way. The reality is that without mortgage insurance, many of those same people would not be homeowners.

I feel it is important to note that this post is not about homeowner's insurance, which is required on all mortgaged properties and protects the home and its contents against loss.

Mortgage insurance covers a lender in the event of a foreclosure. Most homes that go into foreclosure sell for less than market value, so if a homeowner doesn't have much stake in a home, the lender is the one who actually loses money. This is where mortgage insurance comes into play. On purchases with less than 20% down payment or refinances with less than 20% equity in the home, a homeowner obtains a mortgage insurance policy to cover the lender in the event of a foreclosure.

Without mortgage insurance, one of two things would happen:

1. Lenders would stop lending money to people with less than 20% down payment or equity
2. Lenders would raise interest rates to make up for the losses they will undoubtedly incur on foreclosed properties. 

Some people debate that mortgage insurance shouldn't exist and all homeowners should be required to put at least 20% down on a home purchase, but the vast majority of people I have encountered disagree.

Types of mortgage insurance:

PMI vs. MIP

These two terms are often used interchangeably, but they are not the same. PMI stands for private mortgage insurance. This means that the borrower pays a private company to insure the lender against loss. MIP stands for mortgage insurance premium and is specific to FHA loans. MIP is required on all FHA loans and is paid to the Federal Housing Administration (FHA), which insures lenders directly against loss on these types of loans.

Monthly Mortgage Insurance

As the name implies, monthly mortgage insurance is a premium that is paid each month as part of the mortgage payment. It is the most common form of mortgage insurance.

To calculate monthly mortgage insurance, the annual insurance premium is multiplied by the loan amount and divided by 12. Example: If the mortgage insurance on a $200,000 loan is 0.50%, the annual premium is $1,000 (200,000 x 0.5%). If the annual premium is $1,000, the monthly premium would be $83.33 ($1,000/12). This $83.33 is the amount added to the normal mortgage payment each month.

Monthly mortgage insurance may be cancelled at a certain point, which I will cover near the end of this post.

Single Premium Mortgage Insurance

Single premium mortgage insurance is a pretty basic concept. A homeowner pays a lump sum at the time of closing rather than paying a monthly premium. The idea is that if enough homeowners pay this lump sum, that pool of money will offset the small percentage that will result in losses from foreclosure. The disadvantage of the single premium mortgage insurance method is that if you do not keep the loan or home for a long period of time, you paid a large amount upfront when you could have made small payments each month for a short period of time.

Lender Paid Mortgage Insurance (LPMI)

This type of mortgage insurance sounds attractive - after all, the lender is paying right? The actuality is that loans with lender paid mortgage insurance have higher interest rates. The extra interest paid each month is effectively the mortgage insurance premium. So the lender is not actually paying the premium, the homeowner is - in the form of higher interest charges. One major disadvantage of LPMI is that it cannot be canceled since it is built into the interest rate.

FHA Mortgages and MIP

As I mentioned above, FHA insures loans against default with MIP. MIP has two types and they are both required on all FHA loans. The two types of MIP are upfront and monthly.

Upfront MIP (UFMIP) is essentially a form of single premium mortgage insurance. UFMIP is currently 1.75% of the loan amount. FHA allows the UFMIP to be financed, which means a homeowner can add it to the loan amount rather than paying the premium out of pocket at the closing. UFMIP is required on all FHA loans regardless of credit score, down payment, loan term or any other factor.

Monthly MIP is the FHA version of the monthly mortgage insurance section. The monthly MIP amount is dependent on the loan term and down payment and is currently significantly higher than PMI options, which is one of the disadvantages of FHA loans. Canceling monthly MIP has become increasingly difficult recently, which is discussed later on.

Conventional Loans - Conforming & Jumbo

Conventional loans with less than 20% down payment require come sort of PMI, be it monthly, single premium or lender paid. The most popular choice for homeowners is monthly PMI because it doesn't require a lump sum and it can be cancelled after a certain amount of time (see below).

USDA Loans

USDA loans have a form of upfront mortgage insurance called a Guarantee Fee. Currently, this fee is 2% of the amount financed on all purchase and refinance loans and can be added to the loan as discussed in the FHA section. USDA loans also have monthly PMI, which is set at an annual rate of 0.40% right now.

VA Loans

VA loans have a form of upfront mortgage insurance known as a Funding Fee. The Funding Fee on VA loans varies depending on how many times a veteran has used their VA eligibility, the down payment and the type of veteran (regular military, reserves or disabled). Disabled veterans and surviving spouses of veterans who died in service or due to service related injuries are exempt from the Funding Fee. VA loans do not have monthly mortgage insurance, even with 0% down, which is one of the major benefits of the VA loan program.

When can I stop paying mortgage insurance?

This is a separate and somewhat complex issue depending on the loan type and other factors. I have written a separate article here addressing this topic: How do I cancel my mortgage insurance (PMI, MIP)?

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