What is Mortgage Insurance and Why do You Have to Pay It?

Mortgage insurance is a fee lenders charge when consumers are putting less than 20 percent down on a home loan. The reason lenders charge this fee is because the less money someone puts down, the riskier the loan is and the mortgage insurance helps mitigate that risk. There are many different types of mortgage insurance and a few loans that don’t charge mortgage insurance. Some mortgage insurance can be removed after a certain amount of time and some can’t. The cost of mortgage insurance also varies greatly depending on the loan program you use.

Why do lenders require mortgage insurance?

In 1934 the Federal Housing Authority (FHA) was created to help the economy during the great depression. For the most part everyone had to have 20 percent down to get a loan prior to FHA. Most banks thought 20 percent down payments would show consumers they could afford a house. The practice of putting 20 percent down made the housing market much more stable, but it also meant much fewer people could own a home.

The more people who own a home and the more houses that are bought and sold the better our economy does. That is why there are huge tax incentives when buying a house as an owner occupant or as an investor. The government encourages home owners to buy houses with less than 20 percent down by offering FHA insured loans. FHA was not meant to finance homes, but to create insurance for banks who gave consumers loans with less than 20 percent down. There are also many private mortgage insurance companies that allow conventional loans with less than 20 percent down.

Once you started lending on less than 20 percent down, the risk of default increases greatly and it is not worth the risk for banks to lend money. To help mitigate that risk lenders charge mortgage insurance to the borrower, which may be about one percent of the loan amount per year. The mortgage insurance allows banks to lend to borrowers who can’t put that 20 percent down, because the insurance will reduce the losses the banks incur in a default.

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What are the basics of buying a house?

Does the bank get to keep the mortgage insurance?

Although the bank requires mortgage insurance on properties with less than 20 percent down, the bank doesn’t keep the money paid for mortgage insurance. On conventional loans private mortgage insurance companies take the premiums and if a property defaults, the mortgage insurance company will either take the property or pay off the bank for the amount insured.

With FHA loans the mortgage insurance is paid to the federal government and they insure the loans for the banks. FHA homes that go through foreclosure that are taken back by the government become HUD homes.

How much is mortgage insurance on residential properties?

FHA has set guidelines for how much mortgage insurance is. The current cost is 1.75 percent upfront and the monthly fees vary based on the amount of the loan. More information can be found here. The amount FHA charges changes frequently since FHA must keep two percent of its total liability as cash. Due to the housing crisis the fund dropped well below two percent, which caused FHA to increase mortgage insurance.

The upfront mortgage insurance is paid when the buyers close on their new home and the monthly payments are made as long as the loan exists. On a $100,000 loan the payment would be $506 (without taxes and insurance) based on a 4.5 percent interest rate and the payment would increase to $574 after FHA mortgage insurance is added. The upfront mortgage insurance cost would be about $1,700 which can be financed into the loan.

Private mortgage insurance varies with different banks and different loan programs. Private mortgage insurance typically costs from 0.5 percent to 1 percent of the entire loan amount every year. On a $100,000 loan the homeowner would be pay $83.33 per month or $1,000 a year with a 1 percent fee.

Here is a great article on how PMI helps borrowers afford homes.

Can private mortgage insurance (PMI) be removed?

FHA mortgage insurance cannot be removed and lasts the entire time the loan is in existence. However, some types of private mortgage insurance can be removed after a certain amount of time and equity build up. Some private mortgage insurance can be removed after two years and if the loan is 75 or 80 percent or less than the value of the home. If your home goes up in value or you pay off a lot of your balance you may be able to get the PMI removed. The lender may require an appraisal or a simple BPO to determine the value of the property.

What loans don’t have mortgage insurance?

Most loans with less than 20 percent down will have some type of mortgage insurance. VA is one loan that does not have mortgage insurance. VA loans can only be used military veterans, active duty or certain honorably discharged military. The details of who can get a VA loan are listed here.

Almost all other loans will have some type of mortgage insurance when you put less than 20 percent down. There is another option to put less money down using a 20 percent down loan and a 2nd loan. The first loan would be 80 percent of the value of the home and the second loan could be 10 or 15 percent of the value of the home. These loans were more common before the housing crisis, but are still available. The second loans that are available now are for owner occupants only and tend to have much higher interest rates than first loans. The actual savings of getting a first and a second is not that great over getting a first with mortgage insurance.

Here is a great article on how to qualify for a loan.

How does mortgage insurance affect real estate investors?

Mortgage insurance does not affect most real estate investors, because they cannot put less than 20 percent down. However, some investors are able to put less money down buying as an owner occupant and then renting out a home after they have satisfied the owner occupant requirement. When an investor buys as an owner occupant with less than 20 percent down they most likely will have mortgage insurance and will have to factor in that expense. If they use PMI they may be able to get the mortgage insurance removed, but on a FHA loan they will not.

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PMI and FHA mortgage insurance will definitely increase the cost of buying a house. However, for many people it is well worth the extra cost to put less money down. At some point you may be able to remove the mortgage insurance, but always check with the lender first, because some private mortgage insurance cannot be removed.

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