Mortgage Insurance 101: How It Works and Who Needs It
Mortgage insurance is an essential component of the home-buying process for many individuals and families. It protects lenders if a borrower defaults on their mortgage payments. For many homebuyers, it’s easy to get caught up in the excitement of finding the right property without considering the financial protections that come with owning a home.
In addition to comparing property prices and homeowners insurance quotes, it’s essential to understand how mortgage insurance works. This guide explains what mortgage insurance is, how it works, and who needs it.
What is Mortgage Insurance?
Mortgage insurance is a policy that protects mortgage lenders or titleholders if borrowers default on their home loan. In most cases, it is necessary when a homebuyer contributes less than 20% of the purchase price as a down payment. A mortgage insurance’ primary objective is to guarantee compensation to the lender or property owner in the event of the borrower’s death or failure to fulfill their lending obligations. Although it increases the monthly payment, it also makes it easier for homebuyers without a large down payment to qualify for a mortgage sooner.
How Does Mortgage Insurance Work?
Lenders typically require a down payment of at least 20% of the property value before offering a mortgage. The requirement is based on the belief that borrowers who invest their money are unlikely to forgo repayment and allow the lender to foreclose on their property.
Borrowers who cannot meet this requirement must purchase mortgage insurance and pay premiums to protect the lender. The premium on your mortgage may be capitalized as a lump sum or paid monthly together with your regular mortgage repayment. You can request a cancellation of your mortgage insurance payment when you’ve built up equity and met up with certain criteria – typically when your principal balance falls below 80% of the original home’s value.
Types of Mortgage Insurance
There are several types of mortgage insurance, each serving a unique purpose and offering protection under specific circumstances.
Private Mortgage Insurance (PMI)
Private mortgage insurance (PMI) is required when the borrower obtains a conventional loan with a down payment of less than 20%. It is designed to protect the lender in case the borrower defaults on the loan. PMI can be canceled once the borrower pays 20% of the principal balance.
Mortgage Title Insurance
Mortgage title insurance protects the lender and borrower against title-related losses. It ensures that both parties are not at risk if it turns out that the property belongs to someone other than the seller at the time of sale.
Qualified Mortgage Insurance Premium (MIP)
Homebuyers who obtain a mortgage from the US Federal Housing Administration (FHA) must purchase MIP regardless of their down payment size. This mortgage also protects the lender if the borrower defaults on their repayment.
Mortgage Protection Life Insurance
Mortgage protection life insurance pays off a borrower’s mortgage balance if they die before fulfilling their obligations. It is designed to protect the borrower’s family from losing their home if they pass away. The premium on mortgage protection life insurance remains level throughout the term, but the payout can be either declining-term or levels, depending on policy terms.
Who Needs Mortgage Insurance?
Mortgage insurance requirements vary among lenders, but this group of people would likely need mortgage insurance when buying a home.
- Homebuyers with a low credit score.
- Homebuyers with a high debt-to-income ratio.
- Homebuyers who are self-employed or have irregular income.
- Homebuyers using non-traditional mortgage products such as interest-only mortgages.
- Homebuyers purchasing a high-value property or multi-unit property (duplexes, triplexes).
- Homebuyers refinancing their mortgage with a loan-to-value (LTV) ratio of more than 80%.
- Homebuyers using government-backed loans – loans backed by the FHA, USDA, or Department of Veteran Affairs.
- Homebuyers purchasing a home in a high-risk area – places prone to floods, tornados, or other disasters.
Factors Affecting Mortgage Insurance Premiums
How much you’ll pay for your mortgage insurance will depend on the following factors:
Credit Score
Borrowers with higher credit scores are considered as less risky clients. If you have a low credit score, you will most likely pay a higher premium on your mortgage insurance.
Loan-to-Value (LTV) Ratio
Loan-to-Value (LTV) ratio is a percentage that represents your mortgage amount with the appraised value of the property. It’s calculated by dividing the loan amount by the property value. LTV ratio can affect how much you pay as a mortgage insurance premium. A high LTV ratio (85% or more) may lead to higher premiums and stricter insurance terms. The lower your LTV ratio, the lower you’ll pay for insurance premiums.
Property Value
Mortgage insurance companies may consider high-value properties riskier to insure since there’s more money at stake. They will typically charge higher premiums on those types of homes.
Location
The location of the property you want to buy can also affect your mortgage insurance premium rates. Homes in desirable neighborhoods with low crime rates, good schools, and easy access to amenities will have lower mortgage insurance premiums. Properties in states or regions with strong economies and high demand are considered valuable and may also command lower mortgage insurance premiums.
Homes in regions with high crime rates, environmental hazards, lower foreclosure rates, and economic instability are riskier to insure and will command higher insurance premiums.
How to Cancel Your Mortgage Insurance
You can request to cancel your mortgage insurance when your mortgage balance reaches 80% of the total property value. Canceling your mortgage reduces how much you’ll pay to service the mortgage monthly.
Your insurance provider is legally required to grant your cancellation request provided you meet the following criteria:
- Provide a written cancellation request
- Have a good payment history
- Prove there are no other liens on your mortgage
- Show proof that the home hasn’t declined below its original value
Conclusion
Mortgage insurance is a crucial part of home buying as it can significantly impact the overall cost of homeownership. By learning about mortgage insurance and what it entails, homebuyers can make informed decisions about their mortgage options, potentially saving thousands of dollars in insurance premiums over the life of their loan.
