The ABCs of mortgage insurance
Mortgage insurance basics
- Mortgage insurance protects the end investor against the risk of default.
- Insurance on FHA loans is mandatory and can’t be canceled.
- PMI is typically not mandatory for borrowers who put 20 percent down, and can be canceled.
Most people probably know that they have to pay interest on a home loan, but that’s not the only expense that plays into a borrower’s monthly mortgage payments.
A borrower also is charged several fees, and a widely misunderstood one is mortgage insurance.
Most home buyers will have to carry mortgage insurance for at least a few years and, in some cases, for the entire term of the loan.
Unlike fire or flood insurance, however, mortgage insurance doesn’t protect the homeowner against loss, but shields the lender from losses in case the loan defaults. To be more precise, mortgage insurance protects the investor that purchases the loan and holds the default risk.
Mortgage insurance is usually separated into the broad categories of government and private mortgage insurance.
FHA guaranteed loans
The Federal Housing Administration (FHA) backs the most widely used government loan program.
FHA doesn’t purchase loans, but guarantees the loan for the end investor in case of default. That federal guarantee, in turn, has made FHA loans more widely available to borrowers without a deep credit history or with lower credit scores.
FHA charges an upfront, one-time insurance payment, and also charges an annual mortgage premium that is equally distributed in 12 monthly installments.
The cost of FHA insurance — which is based on fixed percentages of the total loan amount — has changed several times in recent years. Consumers should be sure to check with their loan officer to get the most updated figures and to assess how much that insurance costs compared to conventional loan programs that require private insurance. The insurance, though, is mandatory for an FHA loan.
Regardless of the size of the down payment, borrowers must pay the upfront insurance cost, and must carry the annual insurance for the entire length of the loan.
Conventional loans, or loans typically purchased by the government-sponsored enterprises Fannie Mae and Freddie Mac, are the most common type of loan. In some cases, a borrower will have to carry insurance. In other cases, a borrower will not.
The terms and payment methods for private insurance are more flexible and variable than government loans, said Vance Edwards, marketing program director at the Mortgage Guarantee Insurance Corp., one of seven companies that offer private insurance.
“On the private side, it is not a one-size-fits-all like FHA,” Edwards said.
Lenders, for example, typically won’t require mortgage insurance if the borrower puts at least 20 percent down on a home. Most lenders and the end investors, like Fannie or Freddie, however, do require insurance if the down payment amount is less than that.
“The investor, at the end, wants that insurance on there,” Edwards said. “It is on there at that number [because] statistically the less that you put down, the more likely you are to go into default,” Edwards said. “A lot of times it is a short jump from default to foreclosure.”
Unlike FHA, private mortgage insurance can typically be canceled once the borrower pays off 20 percent of the loan. It also can be canceled when the appraised value of the home exceeds 20 percent of the loan value. This is important, Edwards said, because it means that if property values rise significantly in an area, a borrower can often remove this expense earlier than expected.
The fees for private insurance can be structured in several ways. Under the most common scenario, the borrower pays a monthly fee, but the payments can also be structured in other ways. For example, the lender can pay the insurance and roll the costs into a higher interest rate.
During the lead-up to the recession, many people avoided paying mortgage insurance altogether by taking out second loans, known as “piggyback loans,” which covered the cost of the down payment. In some cases, the borrower put nothing down on the home and still paid no insurance. Edwards said piggyback loans largely went away as an option during the credit crisis when investors paid the price for their loose underwriting standards. As credit has become more freely available, however, piggyback loans have come back to a limited degree as a way to avoid private mortgage insurance.
Edwards said a piggyback loan has some downsides, and a borrower shouldn’t automatically take one out if available. Unlike mortgage insurance, a second loan can’t be canceled, he said. The homeowner could potentially continue to pay interest on that second loan long after private insurance could have been canceled.
“Another thing is if you come into problems, and you need to do a refinance to fix a roof or something like that, it is going to get a little tougher because you already have the second mortgage,” Edwards said. “You are kind of limiting your options down the road as well.”