What Is an Insured Mortgage and How Does It Work?

Why Mortgage Insurance is Needed

Mortgage insurance serves a role in the housing market for both lenders and borrowers. For lenders, this insurance mitigates the financial risk associated with loans with smaller down payments, less than 20% of the home’s purchase price. It provides a layer of protection against potential losses if a borrower defaults on their mortgage obligations. This coverage allows financial institutions to extend credit more broadly, reducing their exposure when the loan-to-value ratio is high.

This risk reduction for lenders benefits aspiring homeowners. With mortgage insurance, borrowers can secure a home loan with a significantly lower upfront investment than the traditional 20% down payment. This increased accessibility helps many individuals and families achieve homeownership sooner, who might otherwise need years to save a substantial sum. Mortgage insurance makes it feasible for lenders to offer these loans, expanding the pool of eligible buyers.

Types of Insured Mortgages

Insured mortgages fall into two main categories: those backed by government agencies and those covered by private mortgage insurance. Each type serves distinct purposes and caters to different borrower profiles. Understanding these distinctions is important for home financing.

Government-backed insured mortgages are supported by federal agencies to promote homeownership. Federal Housing Administration (FHA) loans assist first-time homebuyers or those with lower credit scores or smaller down payments. These loans require Mortgage Insurance Premiums (MIP), including both an upfront payment and annual premiums.

Loans guaranteed by the U.S. Department of Veterans Affairs (VA loans) benefit eligible veterans, active-duty service members, and certain surviving spouses. VA loans do not require a down payment and do not have ongoing monthly mortgage insurance premiums. Instead, VA loans include a one-time VA funding fee, which helps sustain the program.

Another type of government-backed loan is the U.S. Department of Agriculture (USDA) loan, which aims to promote homeownership in eligible rural areas. These loans offer favorable terms, requiring no down payment, but have specific income and property location eligibility requirements. USDA loans include both an upfront guarantee fee and an annual guarantee fee, functioning similarly to mortgage insurance.

Private Mortgage Insurance (PMI) applies to conventional loans and is required when a borrower’s down payment is less than 20% of the home’s purchase price. Unlike government-backed insurance, PMI is purchased from private companies, not a federal agency. It protects the lender against financial loss if the borrower defaults on a conventional loan.

How Mortgage Insurance Works and Its Costs

Mortgage insurance premiums are calculated as a percentage of the loan amount and can be paid in various ways. For private mortgage insurance (PMI), payments are made monthly as part of the mortgage payment, though sometimes an upfront lump sum or a split premium (part upfront, part monthly) is an option. PMI costs range from 0.19% to 1.86% of the loan amount annually, influenced by factors such as credit score and loan-to-value (LTV) ratio.

Mortgage insurance, regardless of its type, protects the lender in the event of borrower default, not the borrower. If a borrower faces financial hardship and cannot make payments, the insurance does not cover their mortgage obligations. Instead, it compensates the lender for losses if a foreclosure occurs and the sale proceeds do not cover the outstanding loan balance.

For conventional loans with PMI, the insurance can be canceled once a certain amount of equity is achieved. Borrowers can request cancellation when their loan balance reaches 80% of the home’s original value. Federal law, specifically the Homeowners Protection Act, also mandates automatic termination of PMI when the loan balance is scheduled to reach 78% of the original value, provided payments are current.

FHA Loans

FHA loans require an upfront Mortgage Insurance Premium (MIP) of 1.75% of the loan amount, and annual MIP that varies based on loan size, term, and LTV. For FHA loans originated after June 3, 2013, if the down payment was less than 10%, the annual MIP is paid for the entire life of the loan; with a 10% or greater down payment, it may be removed after 11 years.

VA Loans

VA loans do not have ongoing monthly mortgage insurance, but they include a one-time VA funding fee ranging from 0.5% to 3.3% of the loan amount, which can be financed into the loan.

USDA Loans

USDA loans have both an upfront guarantee fee, currently 1% of the loan amount, and an annual fee, currently 0.35% of the loan amount, which is paid monthly and continues for the life of the loan.