Imagine you’ve found your dream home, and you’re ready to take the big step of becoming a homeowner. But as you navigate through the mortgage process, you come across the term “mortgage insurance.” What exactly is it, and why is it important?
Mortgage insurance is a crucial element in home buying, especially if you’re unable to make a large down payment. It’s designed to protect lenders from potential financial losses if borrowers default on their loans.
Understanding how mortgage insurance works and its impact on homeowners is essential for making informed decisions about your mortgage.
In this article, we’ll explore the ins and outs of mortgage insurance, from how it works to the alternatives available.
What is Insurance?
When an insurance policy is in place, it means there’s an agreement between two parties: the insurance company and the person being insured. The purpose of this agreement is to provide protection against unexpected events like death or property damage.
But does this mean the insured person can just receive financial protection without any responsibilities? Well, that’s certainly not the case. The insured makes payments that are otherwise referred to as premiums.
But insurance is not limited to owned properties, you can insure monies you loan out as well.
A mortgage is a legal agreement in which a person borrows money to buy properties (such as a house) and pays back the money within a particular time as agreed by both the lender and the borrower.
Since insurance in itself protects against unpredictable situations, mortgage insurance protects the one who lends out money or a title holder, should the borrower be unable to pay their debt by not complying with the agreement or pass away.
Who mortgage insurance is for
While other types of insurance may benefit the borrower, mortgage insurance does not benefit those who borrow.
It aims to protect the lender from losses when the borrower fails to comply with the contract, passes away, or for any other reason for which payment on the mortgage cannot be made. If you’re a lender, then mortgage insurance is for your benefit.
How mortgage insurance works
Mortgage insurance pays the lender a certain portion of the principal should you as the borrower fail to meet up with the agreement of repaying the loan at the time agreed upon or pass away. This prevents the lender from suffering any losses.
Private mortgage insurance
If as a borrower, what you can afford is less than a 20% down payment on your mortgage, you will be required by your lender to buy private mortgage insurance otherwise known as PMI.
Since the lender will bear most of the financial burden because you have little stake in the home, they have to protect themselves and this can only be achieved through the PMI.
How do you pay for PMI?
There are two ways to pay for your private mortgage insurance. The first, is a one-time upfront premium that is paid at closing or monthly while the other is to pay for it as one of your closing costs.
The closing cost which is between 3% to 6% of the original price, is the amount of money paid to certain professionals such as the mortgage lender and real estate attorney, as a result of carrying out their services. This closing cost depends on your state, loan type, and mortgage lender.
The setback of paying your PMI as one of your closing costs is that if you refinance your mortgage, you may not be refunded your money.
How do you cancel your PMI?
You may not need to pay PMI for the entire period with the help of the Federal Homeowners Protection Act, and this can be done through any of the following ways:
- Borrower Initiated PMI cancellation
- Automatic PMI termination
- Final PMI termination
Borrower initiated PMI cancellation: Here, the borrower takes the step to initiate a loan cancellation when the principal balance reaches 80% of the home value. However, for this to happen, you may have to do the following:
- Be current on your monthly mortgage payments.
- Have a positive payment history — this means not being late on your payment.
- Make your request in writing.
- Satisfy all the requirements of the lender.
Automatic PMI termination: this is when the lender cancels your PMI when your principal balance hits 78% of the home value even if as the borrower, you do not ask him to cancel it. It occurs on the very date the 78% loan-to-value ratio is achieved.
For this to happen, you must be current on your mortgage, and you must not have a second mortgage. If as a person, you have late payments, your lender may not cancel PMI until you are up-to-date on your mortgage payments.
Final PMI termination: this occurs the month immediately after your loan term reaches its midpoint on a repayment schedule. For example, If you have a 20-year fixed loan, the midpoint will be the 10th year making it possible for cancellation, but you must be current on your mortgage to qualify.
Additionally, you can cancel your PMI faster if your home value increases. Otherwise, it will take a longer time for you to terminate it.
Mortgage Insurance Premium
This is another type of mortgage insurance. It is required from homeowners who take out loans supported by the Federal Housing Administration. When a bank or any other lender issues a loan as approved by an agency, and insured by the government, it is called a Federal Housing Administration (FHA) loan. Loans of this nature are typically insured and require upfront payment.
How to cancel mortgage insurance premium
If you have a Federal Housing Administration (FHA) loan, canceling the mortgage insurance premium (MIP) might not be possible. It depends on when your loan was originated.
If originated between December 31, 2000, and June 3, 2013, you can cancel the MIP provided you have paid off at least 78% of the loan-to-value amount. However, if originated after June 3, 2013, with a down payment of less than 10%, you’ll be required to continue paying the MIP for the duration of the loan. The only way to cancel the MIP in this case is by refinancing into a non-FHA loan.
Title mortgage insurance
Title mortgage insurance helps to protect both lenders and buyers from unforeseen circumstances, such as a title defect that may result in the loss of properties. For instance, another person claiming ownership of the properties.
This type of mortgage insurance could be a lender’s title insurance which is bought by a borrower to protect the lender, or an owner’s title insurance, bought by a seller to protect the buyer.
Mortgage protection life insurance
Mortgage protection life insurance is designed to provide financial security for homeowners and their families if the insured person passes away. Its main purpose is to cover the outstanding mortgage balance in case of an unexpected death during the policy term.
The coverage amount is typically aligned with the mortgage balance, ensuring that it is paid off if the insured passes away.
Basically, it protects loved ones from the burden of mortgage payments and protects the lender from incurring loses.
Types of mortgage protection life insurance
There are two types of mortgage protection life insurance. They are:
Decreasing term insurance: In this case, the death benefit decreases gradually over the policy term. The benefit amount aligns with the mortgage balance as regular payments are made. It’s ideal for borrowers who have a repayment mortgage or prefer a coverage that matches their declining mortgage balance.
Level-term insurance: This type of insurance offers a consistent death benefit throughout the policy term, regardless of the outstanding mortgage balance. It’s a good choice for borrowers who have a fixed-rate mortgage or want steady coverage.
In mortgage protection life insurance, there are two factors to consider. The lifespan of the policyholder and that of the mortgage. It is, therefore, advisable that before such insurance is bought, the borrower must seek to understand the cost, terms, and benefits of the policy.
Advantages of mortgage protection life insurance
- Relief from worrying about the financial standing of loved ones.
- Mortgage life insurance offers coverage for when the borrower is disabled or unable to work.
- If a borrower dies, becomes seriously ill, and is not able to work, the mortgage life insurance policy will pay off the entire mortgage loan, and the heirs will not be affected nor will they have they worry about what will become of the family home.
How to avoid mortgage insurance
Mortgages can be beneficial to those who want to become owners and while this is true, there could be certain unpredictable circumstances that may occur to the disadvantage of the lender. It is for this reason that mortgages are insured so that if the borrower fails to pay off the mortgage, the lender won’t lose so much as the mortgage insurance can pay off the debt.
However, from the borrower’s point of view, mortgage insurance can be an additional burden and coupled with its potential costs and downsides, it is only natural to try to avoid it. So the following are some ways to do so:
Conventional loans: One can avoid mortgage insurance by making an initial down payment of 20% of the original home value. The only time mortgage insurance is required for conventional loans is if the down payment is less than 20% of the home value.
High-interest mortgages: Also, borrowers can decide to choose a mortgage with a higher interest rate. It will compensate the lender for the additional risk.
Advantages of mortgage insurance
- It can help you become a homeowner.
- It solves the issue of downpayment by offering several options.
- Instead of paying rent monthly, you can buy a home and pay that same amount for rent as the insurance premium.
- If you are self-employed and have good credit, it allows you to access other mortgage loans aside from unconventional loans.
Disadvantages of mortgage insurance
- The premium remains the same even if the mortgage decreases.
- It protects the lender and not the borrower in cases when the borrower defaults.
- Mortgage insurance policies are designed to have decreasing benefits over time. Its benefits decrease as your mortgage loan decreases.
- The money paid out by the policy must be used to pay the mortgage. This may not be convenient, especially at times when other expenses have to be settled.
Steps to get mortgage insurance
- Choose a lender: Find a lender. They’ll give you guidance on mortgage insurance requirements.
- Understand the requirements: If your down payment is less than 20% of the home’s price, the lender may ask you to have mortgage insurance. They’ll explain the specific rules and options.
- Apply for insurance: Once you know that mortgage insurance is needed, the lender will help you apply. They can connect you with insurance providers or handle the application process themselves.
- Provide necessary info: Share your financial and personal details with the insurance provider. They’ll use this information to assess the risk and determine your premiums.
- Pay the premiums
Alternatives to mortgage insurance
Mortgage insurance such as premium mortgage insurance and mortgage insurance premium requires that the borrower pays monthly premiums. However, the borrower may do away with this by opting for Lender-Paid mortgage insurance.
Here, the lender pays the monthly premiums instead of the borrower but charges a higher interest rate to compensate for the premiums. The resulting consequence of this is that the overall cost of the mortgage will be greatly increased depending on how long the mortgage is for.
It is available mostly for conventional loans and is a very good substitute for private mortgage insurance. The advantage of LPMI is that it prevents the borrower from paying monthly premiums. However, one still has to consider factors such as monthly mortgage payments, interest rates, and the required duration of the mortgage.
Other alternatives include
Piggyback mortgage: Also known as a combo loan, here, you take out two separate loans – one for a portion of the home’s value and another for the remainder. By combining these loans, you can avoid mortgage insurance.
VA loans and USDA loans: If you’re eligible, you may qualify for a VA loan (for veterans and active military members) or a USDA loan (for certain rural and suburban homebuyers). These loan programs often have more favorable terms and may not require mortgage insurance.
Just like the name suggests, velocity banking helps speed up the repayment process as a 30-year mortgage can be paid within a shorter time frame, say 5 or 7 years for example. The method makes use of a home equity line of credit otherwise known as HELOC to pay off the mortgage faster than one ordinarily would. Instead of paying the mortgage bit by bit, it allows you to pay the principal balance in large sums. The following things must be put in place if you must try out this method:
- You must have a good credit score, say, 680 or more.
- You must have a positive cash flow. This means that your income must exceed your expenses.
- You must have a credit card for your normal living expenses.
- You must ensure to also have equity in your home.
Velocity banking, when applied to mortgages, aims to accelerate the repayment of a mortgage loan while minimizing interest costs. The strategy typically involves the following steps:
First, the homeowner secures a HELOC – a line of credit backed by the equity in their home. They then use the available funds from the HELOC to make a lump sum payment towards their mortgage principal.
By reducing the mortgage principal, homeowners can potentially decrease the overall interest charges and the time it takes to pay off the mortgage. The key concept behind velocity banking with mortgages is to continue making regular mortgage payments while using the surplus cash flow to pay down the HELOC balance.
As the HELOC balance decreases, more of the homeowner’s regular mortgage payment goes directly towards the principal, further accelerating the debt repayment process.
Mortgage insurance is a great way to protect people who loan out money. If there was no such measure, not a lot of lenders would take the risk of lending their financial resources to people in need of them at any point in time. And the end result would be highly damaging — fewer loans mean fewer people with enough purchasing power, fewer purchases, and ultimately, fewer financial goals being achieved.
Just as consumer insurance is important, lender’s insurance is also vital to the working ecosystem.