Mortgage insurance protects the lender or the lienholder on a property in the event the borrower defaults on the loan or is otherwise unable to meet their obligation. Some lenders will require the borrower to pay the costs of mortgage insurance as a condition of the loan.
What Is Mortgage Insurance?
Borrowers will typically be required to pay for mortgage insurance on an FHA or USDA mortgage. This is also typically required by private lenders on conventional loans when a borrower's down payment is less than 20%. This is known as private mortgage insurance (PMI).
Another form of mortgage insurance is mortgage life insurance. These policies will vary among insurance companies, but generally the death benefit will be an amount that will pay off the mortgage in the event of the borrower's death. The beneficiary will be the mortgage lender as opposed to beneficiaries designated by the borrower.
How Does Mortgage Insurance Work?
Mortgage insurance is something that is required by the mortgage lender under certain circumstances. The premium is paid by the borrower and might be an extra cost added to the monthly mortgage payment or required as an upfront payment. Here are some examples of how mortgage insurance works in different situations.
- PMI is typically required by conventional lenders for borrowers who put down less than 20% when taking out their mortgage. The cost will be added to the monthly payment. The borrower can request that the PMI be canceled when they reach a level where their equity in the property is at least 20%. The process will vary a bit by lender, so be sure to understand how this works before taking out the loan.
- The FHA Mortgage Insurance Premium (MIP) is assessed on all mortgages taken out via the FHA program. The MIP entails both an upfront premium payment at the time the mortgage is taken out, plus an annual payment. The annual payment ranges from 0.45% to 1.05% of the outstanding mortgage balance. If your down payment is 10% or greater, then the MIP payments terminate after 11 years.
- The U.S. Department of Agriculture offers zero down payment loans to promote homeownership in rural and certain suburban areas. The USDA's mortgage program generally requires both an upfront premium payment plus an ongoing annual payment made as part of the mortgage payment. The 2019 amounts are 1% of the loan amount for the upfront fee and the annual fee is 0.35% of the average amount outstanding for the year, this payment is divided into monthly installments.
- Loans made via the Veterans Administration can be had with no down payment and offer attractive rates for veterans, active or disabled service members. Some reservists and qualifying widows are eligible as well. VA loans don't require mortgage insurance per se, but they do require a rather hefty funding fee. This fee ranges from 1.25% to 3.3% of the mortgage loan amount. This fee generally must be paid upfront but can be rolled into the loan and be made as part of the monthly payment. Certain borrowers are exempt from this fee, based upon their circumstances. The VA claims that this fee helps defray some of the costs associated with this program.
What Are the Pros of Mortgage Insurance?
Generally, for the borrower there are no real pros associated with mortgage insurance. It is an extra cost of obtaining a mortgage and needs to be factored into the total cost buying a home and obtaining a mortgage.
Perhaps the one pro is that the use of mortgage insurance by some lenders makes mortgages more widely available to borrowers who might not otherwise qualify.
In the case of mortgage life insurance, these policies can help ensure that the borrower's heirs will be able to keep the home in the event of the borrower's death. Whether this entails allowing the family to avoid losing their home or allowing heirs time to get the deceased borrower's affairs in order and take their time in deciding what to do with the home, this insurance provides peace of mind and options.
What Are the Cons of Mortgage Insurance?
The con of mortgage insurance is the added costs for the borrower. This makes the cost of the mortgage more expensive.
Using the VA example, a funding fee of 2% of a $200,000 loan translates to a cost of $4,000 to the borrower. Whether this is paid as a lump-sum upfront or rolled into the loan this is still an additional cost of borrowing and buying a home.
Is Mortgage Insurance Necessary?
This is a question for the lender to address. Lenders may feel that mortgage insurance or the VA funding fee is necessary to allow them to make loans to borrowers who may have less than stellar financial situations.
Another way to look at this would be to look at the overall cost of programs such as the FHA, VA and USDA programs. In order to determine the impact of the required mortgage insurance or the VA funding fee, borrowers should look at the total cost, including how the interest rate compares to an alternative they might be considering.
The best way to avoid paying for mortgage insurance in any form is to take out a conventional mortgage and to put at least 20% down. If you can't manage this level of down payment, then be sure to factor the cost of the mortgage insurance into your monthly costs or into the money you will need at closing.
It may or may not be an option to borrow some or all of the down payment amount from family members, but this might be a consideration. Additionally, in some cases you may be able to tap your Roth IRA account tax-free and penalty-free for funds for the down payment.
In the case of mortgage life insurance, this can be a great benefit for your heirs and loved ones. On the other hand, you can do much the same thing with term insurance while naming your own beneficiaries. It pays to shop for the best type of life insurance to cover your mortgage costs in the event of your death.
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