If you’re looking to buy your first home, you’ve likely come across the term “mortgage insurance.” It might sound like just another complicated financial concept, but fear not.
This article will demystify mortgage insurance and help you understand why this concept is essential when it comes to the process of purchasing a home.
Globally, mortgage lenders are increasingly being encouraged to lend down-market and develop products that cater for low-income households or households with irregular incomes. However, mortgage lenders face the risk of borrowers defaulting on loan repayments.
Keep reading further to find out what mortgage insurance is, what it covers, the benefits and how it works.
Definition and Purpose of Mortgage Insurance
To begin, let’s start from the basics. What is mortgage insurance, and why is it in existence? At its core, mortgage insurance is a financial safety net, not for you, but for the lender. It’s a way for them to protect themselves in case you can’t meet your mortgage payments for whatever reason.
So, why should you care about mortgage insurance? Well, it plays a crucial role in helping many people become homeowners, especially if they don’t have a hefty down payment saved up. It’s a key that unlocks doors to homeownership that might otherwise remain closed.
When you buy a home, you probably expect to shop around for the best mortgage rates, take out a mortgage and make a down payment. But there’s another step you might need to take. If your down payment is less than 20 percent of your home’s purchase price or you’re taking out a particular mortgage (such as an FHA loan), you might also need to buy mortgage insurance. For lenders, these are higher-risk lending situations, so they require mortgage insurance to protect their interests.
This is because you have less invested in the home upfront, so the lender has taken on more risk in giving you a mortgage. How much you’ll pay is dependent on the type of mortgage loan you have and other factors.Note this, even with mortgage insurance, you’re still responsible for the loan. If you fall behind on or stop making payments, you could lose your home to foreclosure.
Types of Mortgage Insurance
The type of mortgage insurance you’ll need depends on several factors, including the kind of loan you have. Since mortgage insurance protects the lender, your lender chooses the insurer that provides the policy.
Private Mortgage Insurance (PMI)
PMI, or private mortgage insurance, is like your trusted sidekick when you can’t make a 20% down payment. It’s there to protect the lender, but it can also be your ticket to owning a home sooner.
If you’re planning to purchase a new home for $300,000 and your down payment is less than $60,000, for example, you can expect to pay private mortgage insurance (PMI) until you reach the threshold where you can have it removed, typically 20% of your home’s value..
The good news about PMI is that, for the most part, your mortgage lender will calculate its cost and add it to your mortgage payment on your behalf. However, the cost of PMI can vary over time and based on the lender you select.
Generally speaking, PMI will set you back somewhere between 0.22% – 2.25% of your loan amount each year. You won’t necessarily know the exact percentage until you receive the Loan Estimate and Closing Disclosure agreement from a lender.
Federal Housing Administration (FHA) Mortgage Insurance
FHA loans are a lifeline for those who need a more flexible down payment requirement. But they come with their own version of mortgage insurance. Let’s explore what makes them different.
If you get a Federal Housing Administration (FHA) loan, your mortgage insurance premiums are paid to the Federal Housing Administration (FHA). FHA mortgage insurance is required for all FHA loans. It costs the same no matter your credit score, with only a slight increase in price for down payments less than five percent. FHA mortgage insurance includes both an upfront cost, paid as part of your closing costs, and a monthly cost, included in your monthly payment.
If you don’t have enough cash on hand to pay the upfront fee, you are allowed to roll the fee into your mortgage instead of paying it out of pocket. If you do this, your loan amount and the overall cost of your loan will increase.
- Eligibility for FHA Loans
The minimum credit score depends on your down payment. If it is 3.5% of the loan amount, then the minimum credit score is 580. However, if you’re able to offer a 10% down payment, then you might be able to qualify with a minimum credit score of 500.
The minimum down payment for an FHA loan is 3.5% if you have at least a 580 credit score. It’s 10% if your credit score is between 500 and 579. You are allowed to put cash gifts from friends, family, and employers toward your down payment.
Department of Veterans Affairs (VA) Funding Fee
If you’re a veteran, VA loans are a fantastic option. If you get a Department of Veterans’ Affairs (VA)-backed loan, the VA guarantee replaces mortgage insurance, and functions similarly. With VA-backed loans, which are loans intended to help servicemembers, veterans, and their families, there is no monthly mortgage insurance premium. However, you will pay an upfront “funding fee.” The amount of that fee varies based on:
- Your type of military service
- Your down payment amount
- Your disability status
- Whether you’re buying a home or refinancing
- Whether this is your first VA loan, or you’ve had a VA loan before
Instead of traditional mortgage insurance, they have something called the funding fee.
- Eligibility for VA Loans
Generally, all Veterans using the VA Home Loan Guaranty benefit must pay a funding fee. This reduces the loan’s cost to taxpayers considering that a VA loan requires no down payment and has no monthly mortgage insurance. The funding fee is a percentage of the loan amount which varies based on the type of loan and your military category, if you are a first-time or subsequent loan user, and whether you make a down payment. You have the option to finance the VA funding fee or pay it in cash, but the funding fee must be paid at closing time.
You do not have to pay the fee if you are a:
- Veteran receiving VA compensation for a service-connected disability, OR
- Veteran who would be entitled to receive compensation for a service-connected disability if you did not receive retirement or active duty pay, OR
- Surviving spouse of a Veteran who died in service or from a service-connected disability
Department of Veterans Affairs (VA) Funding Fee
The USDA guarantee fee is one of the costs you’ll pay to obtain a USDA loan, which is only available to borrowers in designated rural areas and has no down payment requirement. You’ll pay the guarantee fee upfront and annually, with the upfront fee equal to a maximum of 3.5 percent of the loan and the annual fee equal to no more than 0.5 percent.
Benefits and Drawbacks of Mortgage Insurance
Now that you know about the different types of mortgage insurance, let’s weigh the pros and cons.
Benefits:
You can buy a home with less money down. If you don’t have enough savings for a 20% down payment, you might qualify for a conventional mortgage with a smaller down payment and mortgage insurance.
It gives you more options. You may be able to choose from a wider range of homes if you consider different combinations of mortgage types, mortgage amounts and insurance requirements.
PMI gets automatically removed. A conventional mortgage’s PMI will be automatically removed when your mortgage’s principal balance is scheduled to be 78% of your home’s original value — and you can request to have your PMI removed earlier.
Drawbacks:
It requires higher upfront costs. You may have to pay for part of the insurance upfront, which can increase your closing costs. However, you may also be able to add these upfront fees to your mortgage rather than paying for them with cash.
You’ll have higher monthly payments. The monthly mortgage insurance premium can also increase your monthly housing costs.
It could stick for the life of the loan. With government-backed loans, you’ll have to refinance if you want to get rid of the mortgage insurance payments.
Tips for Managing Mortgage Insurance
Even before you become a homeowner, you need to be aware of the long-term journey. A mortgage may seem to be a clear-cut process — you pay your dues every month, and you’re all set — but it’s not.
It’s a big balancing act. Even a modest home renovation project may end up negatively affecting your finances, causing you to make late payments. Planning can help you avoid financial issues and imminent foreclosure when unexpected situations arise.
Here are important steps to manage your home mortgage:
1. Always Pay your Mortgage On Time
Paying a mortgage on time should be the next step after having gotten one. However, many people still end up with late payments due to circumstances or an inability to keep tabs. If this frequently happens, it can ruin the credit or accrue more interest. There are two options to make the process easier for everyone:
- Sync up mortgage payment schedule: Try contacting your bank and ask if you can sync up your payments when your paycheck comes in. If your pay comes in bi-monthly, make bi-monthly payments as well.
- Use automated transfers: You can set up your automatic payments to your bank or lender directly. This option also prevents issues with checks getting lost in the mail.
You can also set up alarm notifications on your smartphone to avoid missing the due date if you are not comfortable with automatic payments.
2. Be Mindful of your Home Spending
Avoid borrowing money for repair or home improvement. While it may seem easy to pay these additional loans back at first, they can turn into a habit and start accumulating.
Stay ahead of expensive home repairs by dropping some money every month on a repair fund. If you are planning to upgrade your kitchen, it is better to save money for this home project than to get another loan.
3. Seize the Chance to Prepay
If an opportunity presents itself to make an extra payment to the principal on your mortgage, grab it. You can use a portion of an unexpected bonus or windfall to save interest payments throughout your entire loan payment.
Keep in mind, though, that prepaying may not be a good option in some situations. If you are in a high-income bracket but have a low-interest rate, you’ll lose the tax deductions on the interest.
4. Take Advantage of your Mortgage Features
Although it is best to avoid getting another loan for a home improvement, sometimes these renovations can’t wait. But before you open a new loan, check if you can borrow against your existing mortgage instead. Use mortgage features such as this to your advantage. Depending on your lender, some even offer the ability to pause the payment for a month.
5. Be Aware of Taxes and Insurance Bills
Both property taxes and insurance bills almost always go up every year. Most people often lose sight of any increase in insurance premiums because it is getting paid automatically through their mortgage.
When it comes to taxes, some banks will also automatically add this cost to your mortgage. It is best that you know how much they’ll increase so you can prepare your funds ahead of time. It’s also important to save receipts, especially on home improvements, as they may qualify for additional tax deductions.
6. Stop Overpaying your Mortgage Lender
If the borrowed amount is more than 80% of your home’s appraised value, you may be paying private mortgage insurance (PMI). PMI can increase your interest rate by as much as 1%. However, you don’t have to pay for PMI for the entire duration of your loan payment.
You can get your lender to stop requiring PMI payments by showing proof that your mortgage balance is less than 80% of your home’s value. And if your balance is not there yet, do what it takes to get the loan balance down. You can also get a new appraisal for your home if the property value in your neighborhood increases significantly.
7. Learn the Habit of Refinancing
Refinancing allows you to cut down the interest rate on your mortgage by a few percentage points. It can reduce your monthly payment, allowing you to save thousands of dollars over the years. However, it would be best to perform due diligence before choosing this option.
It costs money to refinance, so it’s best to check if paying for the closing expenses will not negatively affect your financial situation. Furthermore, it takes a couple of years before you see the effects of refinancing, and with the cost of living rising every year, it may not be worth it in the long run.
8. Build a Rainy Day Fund
As you use portions of your windfall for prepayment or investment, remember to allocate to your rainy-day funds as well. Try to maintain an amount in your funding that can accommodate up to six months of mortgage payments, including payments for property tax.
9. Always Keep in Touch with your Bank
Communication with your bank should not stop after you get mortgage approval. Even if you don’t want to talk to them directly, try to stay up-to-date by checking their websites. The ideal approach, though, is to maintain a healthy relationship with your mortgage provider, so they can comfortably help you out when you are in a pinch.
How to get rid of mortgage insurance
Mortgage insurance can go away, though it might take some effort. PMI can be eliminated in four ways:
- Wait for your home’s equity to reach 22% for automatic cancellation. PMI must be canceled by the loan servicer when you reach 22% of your home’s equity.
- Request your loan servicer to cancel PMI once your home equity has reached 20%. You’ll typically need to have a good payment history, not be behind on your payments, and not have a second mortgage like a home equity loan or line of credit.
- Get your home reappraised. If home values near you have risen substantially or you’ve made big improvements, you may have more equity in your home than you would otherwise. According to the National Association of Realtors, the typical home appraisal costs between $300 and $400.
- Refinance your mortgage. If you have an FHA loan and want to get rid of MIP (while also having enough equity in your home to avoid PMI), you could lower your monthly payment by refinancing. Just consider the pros and cons of refinancing your home before going with this option, as it could mean paying another set of closing costs, taking on more debt, and lowering your credit score.
Conclusion
Mortgage insurance is a tool that can make homeownership more accessible, even if you don’t have a hefty down payment. But it’s also something you’ll want to manage wisely and, when the time is right, bid farewell to.
Mortgage insurance and life insurance might seem like two distinct types of insurance, but they can work together, especially when you’re a homeowner. See, mortgage insurance is all about protecting the lender if you can’t pay your mortgage. But life insurance? Well, that’s like your safety net for your family.
If a homeowner with a mortgage passes away, life insurance can help ensure that their loved ones can continue to make mortgage payments and maintain the family home. In this way, life insurance complements mortgage insurance by offering broader financial security for the homeowner’s family and helping to preserve their home no matter what life throws their way.
Our expert guidance will empower you to make informed decisions about mortgage insurance as it is an essential part of your home buying journey. So, remember what you’ve learnt, explore your options, and you are on your way to becoming a homeowner. Happy house hunting!