Lenders need insurance too. Lenders protect themselves against the risk of a loan default with mortgage insurance, allowing them to offer loans to borrowers who may be considered higher risk. Below, we will explore the different types of mortgage insurance, how it works, and its benefits and drawbacks for borrowers.
Types of Mortgage Insurance
Mortgage insurance typically comes in two forms: private mortgage insurance (PMI) or mortgage insurance premium (MIP).
When the down payments for conventional loans are less than 20% of the home's purchase price, borrowers are usually obligated to pay private mortgage insurance. The cost of PMI depends on a number of factors such as the borrower's credit score, loan-to-value ratio, and loan term, and is usually added on top of the borrower's monthly mortgage payment.
Alternatively, borrowers of government-backed loans such as FHA loans and USDA loans are typically required to pay a mortgage insurance premium if their down payment is less than 20% of the home purchase price. There is an upfront MIP cost at the time of the loan closing and an ongoing cost that is added to the borrower's monthly mortgage payment. The cost of MIP depends on the borrower's down payment, loan duration, and loan amount.
Either way, both types of mortgage insurance have the same purpose: to eliminate risk if a loan defaults. It's important for borrowers to understand what type of mortgage insurance they may be purchasing, how much mortgage insurance costs and how it will impact their monthly mortgage payments and overall loan costs.
Private mortgage insurance (PMI)
PMI usually costs between 0.3% and 1.5% of the original loan amount per year. So, if a borrower takes out a $200,000 conventional loan with PMI costing 1% per year, they would pay an additional $2,000 per year in PMI premiums, or $166.67 per month. The exact cost depends on the lender and the specific terms of the loan.
Lenders and loan programs have varying requirements. Some lenders have a minimum credit score or debt-to-income ratio criteria, while others may have requirements based on the type of property or location.
It's worth noting that PMI is typically unnecessary for the entire loan duration. Once the borrower's loan-to-value ratio drops below 80%, they may be able to request that their lender remove the PMI requirement. Additionally, some lenders may automatically remove PMI once the borrower's loan-to-value ratio reaches a certain threshold, such as 78%.
Overall, PMI can allow borrowers to obtain a mortgage with a lower down payment, but it does come at an additional cost. Borrowers should put this in careful consideration when evaluating their home loan options.
Mortgage Insurance Premium (MIP)
If the borrower's down payment is less than 20%, mortgage insurance premiums are mandatory for government-backed loans like Federal Housing Administration (FHA) loans and United States Department of Agriculture (USDA) loans. The structure, cost and requirements of MIP varies on the loan program.
Cost
For an FHA loan, the cost of MIP is usually included in the borrower's monthly mortgage payment and is divided into two parts: an upfront mortgage insurance premium fee paid at closing and an annual mortgage insurance premium fee paid over the life of the loan. The upfront MIP fee is typically 1.75% of the loan amount. The annual MIP fee depends on factors like the loan-to-value ratio and loan term and can range from 0.45% to 1.05% of the loan amount.
USDA loans also require an upfront fee and an annual fee for MIP. The upfront fee is typically 1% of the loan amount while the annual fee is usually 0.35% of the loan amount, paid as a monthly premium over the life of the loan.
Requirements
FHA loans and USDA loans have different MIP requirements.
While FHA loans need borrowers to have a credit score of 580 or higher and a down payment of at least 3.5%, USDA loans ask borrowers to meet certain income requirements and to purchase a home in a qualifying rural area.
Financing the upfront MIP fee
Borrowers purchasing a home with an FHA or USDA loan can choose to roll the upfront MIP fee into their loan instead of paying it in cash at closing. This is called financing the upfront MIP fee.
Financing the upfront MIP fee can be attractive for borrowers who don't have the cash available to pay the fee upfront. However, it's important to understand that this increases the borrower's overall loan amount, which leads to higher monthly payments and more interest paid over the life of the loan.
It's also worth noting that not all borrowers can finance the upfront MIP fee. Some lenders may have specific requirements or restrictions, so borrowers should understand all of the terms of the loan before selecting their loan option of choice.
Duration
Another important thing to note is that MIP is typically not removable for the life of the loan. This means that even as the borrower pays down their mortgage and builds equity in their home, they will still be required to pay for mortgage insurance. However, MIP can be removed or cancelled in some situations.
For FHA loans, MIP can be removed when the borrower reaches a specific loan-to-value ratio, typically 78%. This typically means the borrower has made their mortgage payments on time for a minimum of five years. Additionally, the borrower must have paid the upfront MIP fee at the time of closing to be eligible for MIP removal.
For USDA loans, MIP can be cancelled when the borrower's loan balance is paid down to 80% of the property's appraised value. The borrower must also have made all of their mortgage payments on time and have no outstanding debts to the USDA.
Removing or cancelling MIP is not automatic. Borrowers will need to contact their lender and request that MIP be removed or cancelled. The lender may also require an appraisal or other documentation to confirm that the loan-to-value ratio has been met.
Although MIP enables borrowers with lower credit scores or smaller down payments to secure a mortgage, it comes with certain financial drawbacks. Hence, borrowers must thoroughly assess the pros and cons of each loan option with their mortgage lender before choosing their preferred program.
If you have any questions regarding mortgage insurance or the requirements on getting a home loan, reach out to your local Premier Mortgage Resources branch today.
Sources:
https://myhome.freddiemac.com/buying/breaking-down-pmi|
https://www.bankrate.com/mortgages/fha-mortgage-insurance-guide/
