Mortgage insurance, or what you may have heard referred to as "PMI," is not to be confused with homeowners insurance (which is also known as hazard insurance, property insurance, etc.).
Mortgage insurance is an insurance policy that benefits mortgage lenders in the event they have to incur the costs of foreclosing on a property. Lenders require this insurance if the borrower is putting less than 20% down, due to the lender's increased risk in making such a loan. The borrower pays the premium on a monthly basis as a part of their mortgage payment, and the mortgage insurance premium is sent to a mortgage insurance company. If the borrower defaults and the lender has to foreclose, the mortgage insurance company kicks back a portion of the loan amount to the lender.
How much is that premium? It depends on many variables such as property type, credit score, location, current market conditions, etc. But for conventional loans, the range is from about .8% to 1.25%. Example: Take the initial loan amount, let's say $100,000. Multiply it by the rate, for instance .85%, and you get the annual mortgage insurance premium, in this case $850. Divide that by 12 and that's the monthly premium (about $71/mo in this example).
The Federal Housing Administration is essentially a public mortgage insurance company. So when you hear about an "FHA loan," that means the mortgage insurer is FHA. For an FHA loan with a minimum down payment of 3.5%, the annual mortgage insurance rate is 1.15% - higher than MI rates for conventional loans. Additionally, there is an upfront premium due at the closing in the amount of 1% of the loan amount. The upfront MI can either be paid at closing or rolled into the loan. Why pay more for MI by choosing an FHA loan? Because they offer better interest rates and less stringent credit and income requirements than conventional loans, and if you have a non-traditional job/career you're more likely to qualify for FHA.
In some cases, a borrower may qualify to buy out MI (on conventional loans only) by paying a fee at the closing. If the borrower's credit score is high enough (at least 700) and their debt ratio is low enough (45% or lower), they might be able to pay a fee of 1-2% of the loan amount in lieu of paying a monthly MI premium. Using the same numbers in the above example, this would be an upfront fee of $2,000 that would allow the borrower to get out of the $71 monthly premium. In this example, the borrower saves money if they keep the loan for more than 28 months.
Another way to avoid mortgage insurance is to get one mortgage for 80% of the purchase price and a second mortgage for 10% or 15% of the price, which still allows the borrower to put only 5-10% down. This strategy was used, abused, and squeezed to the last drop during the credit bubble, and it is much less common today because of the problems it caused. The problems came about because the second mortgage is always either an adjustable rate mortgage or a variable line of credit with a balloon date - aka "ticking time bomb." [You may have heard of an "80/20" - that's a first mortgage for 80% of the price and a second mortgage for 20%, with no down payment from the borrower. These were all the rage in 2005, then the rates on the second mortgages adjusted 3-5yrs later, payments skyrocketed and homeowners tried to sell. But they owed more than their house was worth because housing prices had already peaked. Enter housing meltdown.]
There is at least one loan program out there that allow borrowers to put down less than 20% but not pay MI. It is called HomePath Mortgage - special financing offered by Fannie Mae only on their foreclosures - and it comes with a minimum 3% down for owner occupants or 10% down for investors, both with no mortgage insurance.
Even if you can't avoid MI, not all is lost. The Homeowners Protection Act of 1998 laid down federal laws that require the cancellation of MI after certain conditions are met. A borrower can request MI cancellation after the loan balance reaches 80% of the initial purchase price, but the lender doesn't have to grant it. However, once the loan balance reaches 78% of the initial purchase price the lender must automatically cancel the MI. Of course there are exceptions - for more detailed info on those, check out this article on the FTC website.
And lastly, the MI premiums you pay may be tax deductible due to the Tax Relief and Health Care Act of 2006. That law created a tax deduction for MI premiums on policies issued on or after 1/1/2007 and was extended for policies issued through the end of 2011. Of course, again, there are exceptions summarized in an article on Bankrate.com, but you should speak with a tax professional to get specifics.
Mortgage insurance isn't looked upon favorably by the public, but it's a necessary evil and I'm glad it's here. Otherwise, every buyer in the nation would need 20% down and the housing market would be infinitely worse off. I'll leave you with a heartwarming, redeeming feature of mortgage insurance companies: MI companies have an interest in preventing foreclosures, because foreclosures mean they have to cough up cash to lenders. So if you ever get behind on your mortgage payment, call the MI company directly and see what they can do.
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