How to Avoid Mortgage Insurance
Mortgage insurance provides a lot of flexibility when purchasing a home. If you’re among the many homeowners who can’t quite afford a 20% down payment, mortgage insurance gives you the option to put less money down. In exchange, an extra fee is added to your monthly mortgage payment.
A mortgage insurance company pays your lender for losses that occur if the loan goes into default. Mortgage insurance can either be public or private, depending on the insurer. The lender takes on additional risk by giving you a home loan with a lower down payment. Mortgage insurance helps reduce this risk.
You may be able to avoid paying mortgage insurance. If you do have to pay mortgage insurance, you can eventually remove it. Either way, understanding how mortgage insurance works and how it applies to you as a home buyer will help save you money in the long run.
Types of Mortgage Insurance
The type of mortgage insurance you’re required to pay varies depending on your loan type. The process for removing mortgage insurance varies as well.
Private Mortgage Insurance (PMI)
Conventional mortgages, which are backed by either Fannie Mae or Freddie Mac, often require private mortgage insurance (PMI). While PMI is arranged by the lender, it’s provided by a private insurance company. In the event that a home buyer defaults on their loan, the insurance company would cover a portion of the lender’s loss.
According to guidelines set by Freddie Mac and Fannie Mae, a borrower is required to pay PMI when less than 20% of a home’s purchase price is provided as a down payment.
There are several ways to pay PMI. The options available to you depend on your lender. Most commonly, PMI is paid as a monthly premium that’s added to your mortgage payment. Other options include an upfront premium paid at closing and a combination of upfront and monthly premiums. When you receive a Loan Estimate from your lender, your PMI information will be included.
Mortgage Insurance Premiums (MIP)
Mortgage insurance works differently for FHA loans. While PMI is provided by private insurance companies, the Federal Housing Administration handles the mortgage insurance premiums (MIP) that FHA borrowers pay. MIP is required on all FHA loans for which an application was completed after June 3, 2013.
An FHA loan is a great option for first-time home buyers because it has lower down payment and credit score requirements (3.5% and 580, respectively).
MIP is paid as an upfront premium as well as an annual premium that’s split into 12 monthly payments. The rate you pay depends on the current rate set by the federal government. If necessary, the upfront premium can be rolled into the loan amount.
Another mortgage option, a USDA loan, requires the borrower to pay a guarantee fee, which is similar to mortgage insurance.
USDA loans help reduce the cost for home buyers living in rural areas and in some suburban areas. Unlike PMI, which is paid to a private insurance company, the guarantee fee is paid directly to the USDA. The fee ensures the USDA will cover a portion of the lender’s loss if the borrower defaults on their loan.
Like the FHA’s mortgage insurance premium, guarantee fees are due upfront and annually. The annual premium is broken into 12 equal installments and paid month to month. The borrower can either pay the upfront fee out of pocket or roll it into their loan amount. Unless you refinance and switch to a different loan type, the annual fee can’t be removed.
How Mortgage Insurance Affects Your Payment
There are many factors that determine the cost of your mortgage insurance. Some of these include the loan type, the loan amount and your credit score. What you pay per month depends on your annual premium, which is calculated as a percentage of the original loan amount.
Here’s an example: If you take out a loan for $150,000 and pay a 1% annual premium toward private mortgage insurance, you would end up paying $1,500 for the year, or $125 per month. However, as you pay down your loan amount, you may be eligible to remove PMI.
Eliminating Mortgage Insurance
Remove Mortgage Insurance with Equity
Typically, PMI is eligible for cancellation once the home’s loan-to-value ratio (LTV) is 80% or less. By law, it must be removed once the home’s LTV reaches 78% based on the original payment schedule at closing, depending on the occupancy and unit type.
A loan-to-value ratio compares how much owe on your loan with the appraised value of your home. Lenders assess your LTV to determine the level of risk involved in giving you a loan. You can calculate LTV by dividing your mortgage amount by your home’s value. As mentioned earlier, the ratio is expressed as a percentage.
For example, let’s say you take out a loan for a home loan for $150,000 and you make a $15,000 down payment. As a result, you end up borrowing $135,000 to cover the remaining cost. Dividing the amount you borrow by the value of your home gives you an LTV of 90%:
$135,000 / $150,000 = 0.9
0.9 x 100 = 90%
In the case above, once the loan has a remaining principal amount of $120,000, the LTV will reach 80% and may be eligible for PMI removal.
Paying off your loan isn’t the only way to reach an 80% LTV. If the value of your home increases over time as you pay down your principal, the equity will bring you to an 80% LTV faster.
Avoid Mortgage Insurance from the Start
When it comes to avoiding mortgage insurance altogether, you basically have two options:
- Make a 20% down payment on a conventional loan. This would automatically make your LTV 80%, allowing you to pay your loan without mortgage insurance.
- Get approved for a VA loan. Among all of the loan types available, VA loans are the only type that doesn’t require mortgage insurance regardless of your down payment. As previously mentioned, the borrower pays a funding fee on their VA loan.
Another option worth considering is PMI Advantage. Quicken Loans allows you to buy a home without having to put 20% down and without having to pay a monthly mortgage insurance payment. With PMI Advantage, you’ll accept a slightly higher mortgage rate and eliminate monthly mortgage insurance payments. While this option still requires PMI on your home, it removes the monthly premium that you would otherwise have to pay.
The Bottom Line
Ultimately, the lender requires mortgage insurance whenever they lend to borrowers they consider to be a higher risk. Mortgage insurance guidelines vary between lending programs. Knowing the loan type you’re considering will give you a better idea of what to expect when it comes to paying mortgage insurance.
If you still have questions, we’re here to help! Give us a call at (800) 785-4788 to speak with one of our Home Loan Experts. They can address any concerns you may have about the mortgage process and help you as you consider becoming a homeowner.