What Is Mortgage Insurance (and How Do You Avoid It)?
When you first buy a home, you may think of your monthly mortgage payment as one solid fee. In reality, your house payment is made up of several different things: principal, interest, property taxes, homeowner’s insurance, and often, mortgage insurance premiums. These are all rolled into one monthly payment.
If you take out a mortgage, you’ll always have to pay principal, interest, property taxes, and homeowner’s insurance (PITI). Here’s a bit about each of those:
- The principal is the actual value of your home and turns into equity over time.
- The interest is how your lender makes money (they’re not in the business of charity, after all).
- Homeowner’s insurance can be wrapped up in your mortgage, too, and is often required by your lender.
- And taxes? Well, you know what they say about death and taxes.
All of these components are required to have a mortgage in 2018. But mortgage insurance is an outlier, and a totally different beast.
Definition of Mortgage Insurance
Mortgage insurance, also called PMI (or MIP, in the FHA program) protects banks when borrowers default on their loans. It’s not like homeowner’s insurance, which protects a borrower from theft and natural disasters.
If you default on your mortgage, the bank takes responsibility for about 80 percent of your home’s value, while PMI or MIP covers the rest. For example, if your home is valued at $100,000 and it goes into foreclosure, the bank would pay $80,000 and mortgage insurance would pay $20,000.
When Mortgage Insurance Benefits You
Although people often try to avoid mortgage insurance, it can actually be helpful in the event of a default. Here’s how. The insurance saves the bank from losing money in the event of foreclosure. However, sometimes, the bank is able to sue you for the remaining balance after the foreclosure sale. This is called a “recourse state.” With mortgage insurance, you’ll wind up paying as little as possible in this event.
Do I Have to Pay Mortgage Insurance?
Lenders don’t require mortgage insurance from all homeowners. However, if you’re planning on financing more than 80 percent of your home’s value, you’ll have to pay for mortgage insurance.
In other words, if your down payment is less than 20 percent of your home’s value, you’ll almost certainly be required to pay PMI or MIP.
The first solution to avoiding PMI or MIP is to save up a bigger down payment. But the advantages to a bigger down payment are even more far-reaching than simply avoiding mortgage insurance.
A bigger down payment means you’ll start paying down the principal of your loan faster. You’ll be closer, from the start, to paying off your home loan. And if you have bad credit, a lender may be more likely to overlook your past mistakes if you come into the bank with a 20% down payment saved up.
Using a Piggyback Mortgage to Avoid Mortgage Insurance
You could do a piggyback mortgage, also called an 80/20 loan configuration, to avoid mortgage insurance. In this situation, you’ll actually take out two loans. The first loan will cover 80 percent of the value of your home, while the other mortgage covers up to 20 percent of your home value.
For Current Homeowners: Getting Out of Mortgage Insurance
All lenders are required to drop your mortgage insurance as soon as you’ve built up 22 percent equity in your home. Most will eliminate this payment once you’ve built up 20 percent equity. If you’re not quite there yet, make a plan to pay more on your mortgage each month (as long as there aren’t penalties for doing so).
Getting out of mortgage insurance depends partly on the type of home loan you have. Here’s a rundown of how mortgage insurance works with each of the main types of mortgages: FHA, USDA, VA, Conventional, and Jumbo.
Mortgage Insurance for FHA Loans
FHA loans are awesome because you can get one with as little as 3.5% down. However, even if you do have a large down payment saved up, you’re still required to pay something called a mortgage insurance premium (MIP).
If you have an FHA loan, you’ll pay MIP in two ways. First, you’ll pay it upfront. This is called UMIP. Then, you’ll pay an annual amount. This amount varies depending on the amount of your loan and your loan-to-value (LTV) ratio.
Mortgage Insurance for USDA Loans
USDA loans, similarly to FHA loans, have an upfront fee that functions like mortgage insurance. This is called the USDA guarantee fee, and it’s one percent of your loan amount. There’s also an annual fee that you can finance into your monthly payments that’s 0.35% of your loan amount.
Mortgage Insurance for VA Loans
The VA loan is backed by the federal government, which serves the same purpose as mortgage insurance. Fortunately for you, this means you don’t really have to pay any kind of insurance on a VA loan! However, there is an upfront fee -- and you can pay it all at once, or finance it into your monthly VA loan payments.
Mortgage Insurance for Conventional Loans
Mortgage insurance for conventional, conforming loans is called PMI (private mortgage insurance). The only way to get out of paying PMI on this type of mortgage is by providing a down payment of 20% or more. If you already have this type of home loan, you’ll need to have paid off 20% of your home’s value in order to ask for PMI to be removed.
Mortgage Insurance for Jumbo Loans
Jumbo loans don’t have specific PMI requirements, as conforming loans do. However, every lender is different, so shop around in order to find a bank that won’t require PMI.