When Is Mortgage Insurance Necessary for a Home Loan?
Demystify mortgage insurance. Understand its necessity for home loans, how it works, and practical strategies for its removal.
Mortgage insurance is a common component of home financing that adds to the cost of homeownership but serves a specific purpose. This policy primarily functions to protect the mortgage lender from financial loss if a borrower is unable to make their loan payments. It is not designed to protect the homeowner, even though the homeowner typically pays for it.
Understanding Mortgage Insurance
Mortgage insurance safeguards the lender against financial loss if a borrower defaults on their mortgage loan. This protection allows lenders to offer loans to individuals who might not otherwise qualify, especially those with smaller down payments, making homeownership more accessible.
Different types of mortgage insurance exist depending on the loan product. Private Mortgage Insurance (PMI) is associated with conventional loans, which are not backed by a government entity. Government-backed loans, such as those from the Federal Housing Administration (FHA), require Mortgage Insurance Premiums (MIP). Veterans Affairs (VA) loans involve a VA Funding Fee, while U.S. Department of Agriculture (USDA) loans have a guarantee fee.
When Mortgage Insurance is Required
Mortgage insurance becomes a requirement under specific conditions, varying by loan type. For conventional loans, Private Mortgage Insurance (PMI) is required when a borrower makes a down payment of less than 20% of the home’s purchase price. This threshold is in place because a lower down payment signifies a higher risk for the lender. Paying PMI allows borrowers to secure a conventional loan even without the traditional 20% equity upfront.
For government-backed loans, mortgage insurance is a standard requirement regardless of the down payment amount. Federal Housing Administration (FHA) loans, for instance, always require Mortgage Insurance Premiums (MIP). FHA loans are designed to be more accessible, allowing for down payments as low as 3.5%. Similarly, USDA loans, which are designed for rural properties, include an upfront guarantee fee and an annual fee that acts like mortgage insurance.
The Department of Veterans Affairs (VA) loans do not require traditional mortgage insurance (PMI or MIP). Instead, VA loans include a one-time VA Funding Fee, which helps sustain the program. However, certain veterans, such as those receiving compensation for service-connected disabilities or Purple Heart recipients, may be exempt from paying this fee. This fee varies based on factors like loan type, prior VA loan usage, and the presence of a down payment.
Paying for Mortgage Insurance
The payment structure for mortgage insurance varies depending on the type of loan. For Private Mortgage Insurance (PMI) on conventional loans, the most common method is monthly premiums, which are included as part of the borrower’s regular mortgage payment. These monthly premiums can range from approximately $30 to $70 per month for every $100,000 borrowed.
Some conventional loan borrowers may have other payment options for PMI, such as a single upfront premium paid at closing, or a split-premium arrangement that combines an upfront payment with lower monthly premiums. Lender-paid mortgage insurance (LPMI) is another option, where the lender pays the PMI, but the cost is embedded into a slightly higher interest rate on the loan. With LPMI, the insurance cannot be canceled later without refinancing the loan.
For FHA loans, borrowers pay both an Upfront Mortgage Insurance Premium (UFMIP) and an annual Mortgage Insurance Premium (MIP). The UFMIP is a one-time charge, currently 1.75% of the base loan amount, which can be paid at closing or financed into the loan. The annual MIP is paid monthly as part of the mortgage payment, with rates varying based on the loan amount, loan-to-value ratio, and loan term, ranging from 0.45% to 1.05% of the loan amount.
USDA loans also have two fees: an upfront guarantee fee, 1% of the loan amount, and an annual fee, 0.35% of the loan amount, which is paid monthly.
Eliminating Mortgage Insurance
Removing mortgage insurance depends significantly on the loan type. For Private Mortgage Insurance (PMI) on conventional loans, federal law, specifically the Homeowners Protection Act of 1998 (HPA), provides clear guidelines for cancellation. Borrowers can initiate cancellation of PMI once their loan balance reaches 80% of the home’s original value, provided they have a good payment history, are current on payments, and the property’s value has not declined.
PMI is also subject to automatic termination by the lender. This occurs when the loan balance is scheduled to reach 78% of the original value of the home, assuming the borrower is current on their payments.
Furthermore, if PMI has not been canceled by either of these methods, it must be terminated at the midpoint of the loan’s amortization schedule, provided the borrower is current. Refinancing the mortgage can also be a strategy to eliminate PMI if the new loan balance results in a loan-to-value ratio of 80% or less.
Eliminating Mortgage Insurance Premiums (MIP) for FHA loans is more challenging than with PMI. For most FHA loans originated after a certain date with a down payment of less than 10%, the annual MIP is required for the entire life of the loan.
If the initial down payment was 10% or more, the MIP may be removed after 11 years. Refinancing an FHA loan into a conventional loan, assuming sufficient equity is present, can be a way to eliminate the MIP requirement. VA loans, which have a funding fee instead of mortgage insurance, do not have an ongoing fee to eliminate, unless the borrower was initially charged the fee but later becomes eligible for an exemption due to a service-connected disability.