What is Mortgage Insurance
One of the most persistent myths of the mortgage lending world is the idea that mortgage insurance (MIP, PMI, etc…) is an evil that borrowers should avoid. Before we get into the truth about mortgage insurance in its various forms, let’s take a little time to discuss what mortgage insurance is and what exactly it does.
In evaluating how well borrowers perform on paying back their loans, one thing that banks have observed is that borrowers who have a higher percentage of equity in their homes, tend to be more committed to paying back their loans. This makes sense since the more a person owns of their home, the less likely they are going to be to miss payments and lose their home to foreclosure.
The ‘sweet spot’ with the lowest risk to banks of not being paid back is the point at which the borrower has 20% or more equity in their homes. This is according to years of data compiled across the country.
The sweet spot creates a bit of a problem though. While banks love it when borrowers have 20% to put down as a down payment, borrowers, and especially first time or second-time borrowers, rarely have 20% to put down for their down payment. Enter the role of Mortgage Insurance.
Mortgage Insurance comes in various forms and costs depending on the particular circumstances of an individual’s loan but it always serves the same purpose. MI is an insurance policy, provided either by a private company (called “Private Mortgage Insurance or PMI”) or is provided by a special fund which is overseen by the Federal Government (called “MIP” or “Mortgage Insurance Premium”). In both cases, the insurance policy promises to protect the lender by repaying a portion of the loan if the borrower stops making their payment.
How Can Mortgage Insurance Help Buyers?
Despite its bad reputation, Mortgage Insurance is actually a HUGE advantage to borrower’s who would never otherwise be able to save up 20% of the value of a home. This is especially true in markets where homes appreciate quickly. Consider that as of this writing, the average home in Denver carries a purchase price of around $450,000.00. If mortgage insurance didn’t exist, borrowers would be forced to save 20% of the purchase price for the down payment. That is a total of $90,000.00! For most savers who are able to save less than $10,000.00 per year, it would take roughly a decade to save $90,000.00. Sadly, by that point, the home will have likely appreciated to a higher price and even more savings will be required to purchase.
Instead, mortgage insurance allows a borrower to provide a much lower down payment (ideally 3%-3.5%) or roughly $13,500.00 to $15,750. All the borrower is required to do then is to pay a monthly premium, much like life insurance or car insurance, to keep the mortgage policy in force. The amount of the monthly premium charged changes depending on a borrower’s credit score, how much they put down, and whether they used a Conventional mortgage or an FHA mortgage.
How Long Do Buyers Have to Keep Mortgage Insurance?
There are also variations in how long the premium will be required. Conventional mortgages will allow the mortgage insurance premium to be cancelled once the loan balance reaches 78% of the value of the home at the time the policy was made. To cancel the policy, borrowers simply need to contact the Mortgage Insurance provider to engage in their process for cancellation. FHA mortgages require that the MIP premium remains in force for most or all of the life of the loan. FHA will also require that the premium be paid in two ways. First, a portion of the premium is required up front, at the closing table. This is called “Up Front Mortgage Insurance Premium” or “UFMIP”. In addition to the up front amount, monthly premiums are also required. Over time, the amount will graduate down and can in some cases be dropped.
Most of the time, however, mortgage insurance can simply be dropped by refinancing the original loan. This only works if the new loan amount will be 80% or less of the current value of the home but this is a very common practice which often allows people to get out of mortgage insurance in 2 to 3 years from the date of purchase.
To see if you have enough equity in your home to drop mortgage insurance, check with your Real Estate Agent to get a feel for the value of your home. From there, divide the outstanding balance of your loan by the proposed vale. If the number is 80% or less, you can likely drop the mortgage insurance.
While it’s given a bad name, borrowers are the real winners when it comes to using mortgage insurance premiums to accomplish the goal of owning a home.
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