Mortgage insurance might sound like it is something that it isn’t. Yes, it is indeed an insurance policy but it’s not a policy that pays the borrowers’ mortgage payments should they begin to default. Instead, it’s an insurance policy with the financial benefit payable to the lender issuing the mortgage. But it’s also a benefit to the borrower.
How it Works
There are two different types of mortgage insurance: Private, commonly referred to as PMI and government-backed. Government-backed mortgage insurance is an insurance policy that accompanies the three government-backed home loan programs of FHA, VA and USDA. These policies provide different specific benefits, but they all provide some lender protection. With an FHA and USDA loan, mortgage insurance compensates the lender in the case of default. Both loans carry two separate types of policies, an annual premium and a one-time premium. The one-time premium is rolled into the final loan amount and the annual premium is paid in monthly installments. But how does it help when you’re ready to buy?
Private Mortgage Insurance (PMI)
Private mortgage insurance (PMI) was introduced in the late 1950s when minimum down payment requirements varied between banks. Up to that point, minimum down payment requirements could be as much as 25% or more. In fact, it could be pretty much anything a lender wanted it to be. Some programs asked for a down payment of up to 50% in some areas. That sizable down payment was a homebuying barrier for many, especially for those saving up to buy their first home and without the benefit of existing home equity. But this is when private mortgage insurance came into play.
A PMI policy covers the difference between the buyer’s down payment and the 20% minimum down payment needed for conventional mortgages. Conventional loans don’t require mortgage insurance when the loan balance is at or below 80% of the current market value of the property. Let’s say that someone has a down payment of 5.0%. Instead of waiting and saving for a down payment of 20% or more, buyers can make a 5.0% down payment with the PMI. This covers the difference between 5.0% down and 20% down, or 15%.
Mortgage Insurance Premiums
Mortgage insurance premiums can vary based upon a few factors. For example, the borrower’s qualifying credit score, the amount of down payment or the type of mortgage being secured. And because they are insurance policies, the rates are set and monitored by the ruling insurance regulatory agencies. That means two different companies will have the same premiums for the exact same lending scenario. Lenders don’t make any profit from the insurance premium. The fees go straight toward the policy.
Mortgage insurance also helps the lender make an approval decision. Home loans with a low down payment are seen as a higher risk compared to someone buying a house with a large down payment. Lenders know that if a loan with a low down payment goes into default, they’ll be compensated by the insurance policy for the prescribed amount.
When a lender does have to foreclose, it’s typically sold in an effort to recover the loan amount that went into default. The insurance doesn’t cover the loan amount, but the difference between a 20% down payment and the actual down payment. Similar to mortgage interest, insurance premiums may be deducted from a borrower’s taxable income. Certain income limits apply.
When borrowers first hear of PMI, they might take it as a negative. PMI isn’t punitive but rather allows homebuyers to purchase a home without having to save up so much money for a down payment.
If you want to buy a home now but don’t have a 20% down payment or simply don’t want to tie up those funds in a home loan, you don’t have to wait. Let’s talk about your loan options and get you into the house you want while saving as much as possible at the settlement table.