A down payment on a home has traditionally been 20% of the total purchase price — but what happens when you don’t have 20% to put down?
Lenders still want to make money off your investment, and sellers still want to offload their houses. But the bank considers you a higher-risk borrower because you have little or no equity starting off — in other words, less skin in the game. So it wants some protection in the event you default.
That’s where mortgage insurance comes in.
What Is Mortgage Insurance?
We typically purchase insurance to protect us against the high costs of medical bills, car repairs and home damage, but mortgage insurance serves a different purpose. Though we as policyholders pay for the insurance, it actually protects lenders in the event that you default on your loan.
And it’s not optional.
That’s right: If you can’t cough up 20% of the price of your home as a down payment on a conventional loan, you’ll have to pay some form of mortgage insurance.
In most cases, your mortgage lender will automatically choose and set up the policy for you. The type of insurance will depend on the type of your loan (conventional, FHA loan, USDA loan and VA loan), and there are different mortgage insurance options to consider for each of those loan types.
Private Mortgage Insurance (PMI)
Private mortgage insurance (PMI) is required on conventional loans for which the borrower cannot put 20% down at signing. Why? If you lose your job, contract a long-term illness or face some other unexpected economic barrier and can no longer make payments on your mortgage, the lender will foreclose on your house. If that happens, PMI limits the lender’s losses.
Carrying required PMI does not protect you if you fall behind on payments. If you default on your loan, your credit score will be damaged and you may ultimately lose your home to foreclosure.
A conventional loan is a mortgage that’s not backed by any government agency; instead, these loans are originated by a bank, credit union or other financial institution.
There are four common types of PMI:
1. Borrower-Paid Mortgage Insurance
Borrower-paid mortgage insurance is the most common type of PMI. It requires no additional funds at closing. Instead, you’ll pay for it as part of your monthly mortgage payment, typically into an escrow account that allows the lender to pay the mortgage insurance company for you.
You can stop paying for it, at the earliest, when you have 20% equity in your home, meaning you have paid off 20% of the total home value (not the loan value, which will be significantly larger due to interest). Once you have reached 22% equity, the lender is required to cancel your mortgage insurance, assuming you’re current on payments. We cover how to stop paying for mortgage insurance later.
2. Lender-Paid Mortgage Insurance
Don’t be fooled by the name: You’ll still be footing the bill for lender-paid mortgage insurance.
Instead of paying a monthly premium for mortgage insurance as part of your mortgage payment, you’ll instead get a higher interest rate on your entire loan. Because the cost of the insurance is built into the loan, you technically can’t cancel this insurance at any point; it’s simply part of the interest rate you pay.
Refinancing becomes your best tactic to get rid of lender-paid mortgage insurance, but refinancing carries its own costs that you’d have to weigh against the cost of the insurance over the lifetime of your loan (typically 15 or 30 years).
So why would you opt for lender-paid insurance over borrower-paid? You could ultimately get slightly lower payments each month, which could help you afford more house or save more for other monthly expenses. The downside is you’ll always pay that monthly amount via a higher interest rate; you won’t reach the point where the cost of insurance vanishes from your monthly payment.
3. Single-Premium Mortgage Insurance
Single-premium mortgage insurance, also called single-payment mortgage insurance, requires buyers to pay for the mortgage insurance in one lump sum payment on the day of closing.
This means you won’t face a monthly premium for your PMI, which and keeps your monthly mortgage payment lower. However, it does mean you will have to pay more due at closing, which is often not possible for buyers who are already struggling to get as close to the 20% down payment as possible.
You may be able to negotiate with the sellers to get them to pay your PMI. If so, single-premium mortgage insurance is the best option.
If you don’t know how long you intend to stay in your house, single-premium insurance is likely not the best choice for you. For example, if you move into your home but then uproot three years later for a new job, you’ll have already paid the entirety of your private mortgage insurance, and there is no refund. Had you opted for PMI with monthly payments, you would have only paid for the time you spent living under the roof.
4. Split-Premium Mortgage Insurance
This mortgage insurance is a hybrid form of borrower-paid and single-premium. You pay a portion of the insurance premium in a lump sum at closing, and you fund the rest through monthly payments.
Consider this option if you’re navigating a delicate debt-to-income ratio, as this will help lower your monthly payment slightly.
Insurance on Government-Backed Loans
Conventional loans are the most common way to fund a home purchase, but borrowers are increasingly turning to Uncle Sam for assistance, especially first-time homebuyers.
1. Federal Housing Administration Loans and the Mortgage Insurance Premium
FHA loans, which are backed by the federal government, are great for buyers with poor credit scores and very little in savings. When you go the FHA route, you can purchase a home with as little as 3.5% down.
While this option can make it easier for younger borrowers to buy a home, especially in a challenging economy, it does come with some tougher terms. When you get an FHA loan, you’ll pay an upfront sum for your mortgage insurance and an annual premium (paid for in monthly installments to your escrow). This operates similarly to split-premium mortgage insurance but is instead called a mortgage insurance premium (MIP).
The upfront amount is 1.75% of the total loan amount while the annual premium can range from 0.45% to 1.05% of the average outstanding loan balance in a given year.
Don’t have the 1.75% to pay upfront? The FHA allows you to add it to your loan, meaning you’ll pay interest on it over the life of the loan as well. For example, if you buy a $200,000 house and put 3.5% down, you’ll owe $7,000 as a down payment and $3,500 as your upfront mortgage insurance premium. Assuming you cannot afford the $3,500 premium, you’ll be financing and paying interest on $196,500 — rather than $193,000.
The kicker? If you put less than 10% down on your house when getting an FHA loan, you’ll have to pay mortgage insurance for the life of the loan. If you put 10% or more down, you will pay a MIP for the first 11 years of the loan.
2. U.S. Department of Agriculture Loans
If you are purchasing a home in a rural area, you may be eligible to apply for a home loan from the USDA. To see if you qualify, visit the USDA website.
If you qualify, you’ll have a zero-dollar down payment. However, you must pay an upfront amount on mortgage insurance and an annual fee. The federal government regularly evaluates these percentages and updates them as necessary, but you’re locked into the percentage you’re quoted at closing for the life of the loan.
3. Veterans Affairs Loans
The VA offers one of the best deals for financing a home, requiring no down payments and typically carrying low interest rates. It’s exclusive to active, retired or disabled members of the United States military; qualifying members and reservists of the National Guard; and eligible spouses.
VA loans typically carry a funding fee, ranging between 1.25% and 3.3% of the total loan amount, due at closing.
How to Avoid Mortgage Insurance
Mortgage insurance is a necessary evil. Without it, many of us would not be able to buy our first — or any — home because lenders wouldn’t want to assume the risk associated with the lower down payments that many borrowers rely on to get their foot in the door.
The only way to avoid mortgage insurance is to pay cash for your home or be able to fund at least 20% at closing. Otherwise, no matter what form of loan you take on, someone — whether the bank, the credit union or Uncle Sam — is going to require mortgage insurance.
How to Get Rid of Mortgage Insurance
So if most borrowers have to take on mortgage insurance, whether PMI or MIP, how can they eventually get rid of it? It varies by loan type.
Getting Rid of Borrower-Paid Mortgage Insurance
It’s possible to get rid of PMI well before it comes off your monthly statements. Once your loan-to-value (LTV) ratio drops below 80% (in other words, once you hit 20% equity in your home), you can contact your lender to cancel your insurance. This generally takes about 11 years.
Loan-to-value is calculated by dividing the mortgage amount by the appraised property value. So if you owe $90,000 and the property is valued at $100,000, the LTV ratio is $90,000/$100,000, or 90%.
In today’s market, chances are good that your home’s value is more than what you paid for it. For example, if you purchased your home for $100,000 and you owe $85,000 on it, your LTV is 85%. That means you’d still need to pay for PMI.
However, if your home’s value has shot up to $150,000 and you still only owe $85,000 on it, your LTV is now 57%. In that case, your LTV has dipped below 80%, and you can get rid of your mortgage insurance.
To do this, you’ll need to get a professional home appraisal to confirm that your house has grown in value. Appraisals average about $300 to $450, but this can be well worth the cost if it allows you to stop paying for PMI several years ahead of schedule.
If you don’t proactively cancel your PMI when you’ve reached 80% LTV, lenders will continue to bill you for it. However, when you hit 78% LTV (or 22% equity), lenders are legally required to stop charging you for the insurance. Be proactive in understanding your loan-to-value ratio so you can cancel it as soon as you hit that threshold.
Making extra payments toward your principal can shave years off the length of your loan. If you can, try to make one extra payment each year, which will all go toward the principal.
Getting Rid of Lender-Paid Mortgage Insurance
The only way to get rid of lender-paid insurance is by refinancing.
Refinancing carries its own financial burden. The cost to refinance a home typically ranges from 2% to 6% of the loan amount and includes costs like the appraisal fee, origination fee and home inspection, which can total several thousand dollars. But by refinancing at a lower interest rate — even a half- to three-quarters of a percentage point less than you currently pay — you’ll still save more over the life of the loan.
Getting Rid of the FHA’s Mortgage Insurance Premium
Depending on your initial down payment, you might be out of luck when it comes to eliminating your MIP. If you put down less than 10% for your FHA loan, you must continue to pay mortgage insurance for the duration of your loan. Those who put 10% or more down can eliminate mortgage insurance after 11 years.
Alternatively, you can refinance your FHA loan as a conventional loan. Remember that refinancing carries costs, but if it helps you avoid paying thousands of dollars in mortgage insurance, it may be well worth it in the long run.
How Much Does Mortgage Insurance Cost?
Mortgage insurance comes in many flavors, and several factors can affect the cost. For traditional PMI on a conventional loan, the annual premium ranges from 0.55% to 2.25% of the loan value. Making a larger down payment and having a strong credit score can drive down your PMI costs.
Mortgage insurance, whether PMI or MIP, is costly and is the only conceivable type of insurance that is without benefit to the policyholder. However, without it, many of us would struggle to buy homes with the lower down payments we can afford.
If you have enough money to put down on a conventional loan or 10% on an FHA loan, you’re in good shape to eventually eliminate your mortgage insurance. As long as you monitor your loan-to-value ratio closely, you will be able to proactively cancel your insurance as soon as your contract allows.
And if you make those extra payments on the principal each month or year, that day you can say sayonara to mortgage insurance may come sooner than you think.
Timothy Moore is a market research editing and graphic design manager and a freelance writer covering topics on personal finance, travel, careers, education, pet care and automotive. He has worked in the field since 2012 with publications like Codetic, Debt.com, Ladders, WDW Magazine, Glassdoor and The News Wheel. He lives in Ohio with his fiance.