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What is mortgage insurance and how does it work?

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Just when you think you’ve figured out the homebuying process, a bomb drops -- mortgage insurance. This extra cost can really derail your plans. The good news is that with the right information and planning, it doesn’t have to! So here’s everything you need to know about mortgage insurance: 

What is mortgage insurance?

Mortgage insurance is a type of insurance that is designed to protect the lender when you buy a home. This additional cost mitigates some of the risk to the lender in the event that you default on your mortgage loan. As a result, mortgage insurance makes homebuying more accessible to those with lower credit scores and down payment amounts

What are the 3 different types of mortgage insurance?

There are three different types of mortgage insurance that you need to know about before purchasing a house: borrower-paid, lender-paid, and FHA. Let’s explore each one in more detail: 

1. Borrower-paid mortgage insurance

When you talk about mortgage insurance, you’re likely referring to borrower-paid mortgage insurance (BPMI) in most cases. This type of mortgage insurance is included within your monthly mortgage payment in addition to other costs like property taxes and homeowners insurance and will typically run about 0.5% to 1% of your loan amount per year. BPMI can be dropped once you have paid off 22% of the value of the loan. 

2. Lender-paid mortgage insurance

Lender-paid mortgage insurance (LPMI) involves the lender initially covering the cost of your mortgage insurance in exchange for a higher mortgage rate. Although the increase varies, you can expect to be charged about 0.25% to 0.5% more for LPMI. Furthermore, this type of mortgage insurance cannot be dropped after achieving a certain amount of equity in the home -- you’re on the hook for it throughout the entire loan term. 

3. FHA mortgage insurance

If you’re buying a home using an FHA-backed loan, then you will be required to purchase a type of mortgage insurance known as a mortgage insurance premium (MIP). Unless you make a down payment of 10% or more, you will be required to pay MIP throughout the entire loan term. 

You pay some of your MIP upfront when you close on the loan -- usually about 1.75% of the loan amount. This is known as UFMIP. Then, you will also pay an annual mortgage insurance premium similar to that seen with BPMI of about 0.45% to 1.05% of the base loan amount. 

How does mortgage insurance work?

When you apply for your loan, your lender will determine whether or not you need mortgage insurance. If you have a down payment of less than 20% of the purchase price of the home, they will likely require that you pay this additional cost. They will then calculate your exact insurance rate based on your risk factors. 

From there, they will determine your annual premium and divide it by 12 to get your monthly cost. This amount is automatically added to the amount of your mortgage payments on top of principal, interest, and taxes. Once you have reached 20% equity in your mortgage, you can request to drop your mortgage insurance and the monthly cost of your mortgage will decrease as a result. 

How much does mortgage insurance cost?

Unfortunately, there is no easy answer to this question as your mortgage insurance rate varies based on a whole host of different factors, including things like insurance type, mortgage type, mortgage term, loan-to-value (LTV) ratio, credit score, home value, and additional risk factors as determined by your lender. 

Generally speaking, you can expect to pay anywhere between 0.5% and 1% of the value of your loan in mortgage insurance per year. To properly plan ahead for the costs of mortgage insurance, you should use the higher end of 1% to make your estimates. So let’s say that you take out a mortgage of $285,000 after a down payment of 5% on a $300,000 home. 

With a mortgage insurance rate of 1%, you should expect to pay around $2,850 in mortgage insurance each year. Your lender will consolidate this amount into your monthly mortgage payments for an estimated extra cost of $237.50 per month. Remember to also add in things like property taxes and homeowners insurance when estimating your monthly mortgage payments

How to avoid or get rid of mortgage insurance?

In an ideal world, you could avoid the extra costs of mortgage insurance. However, it’s not always possible. One way that you can avoid having to pay mortgage insurance is by putting down over 20% of the property purchase price. You could also avoid having to pay mortgage insurance by using a USDA loan if you’re in a rural area or a VA loan if you’re a veteran. 

If you can’t swing making a 20% down payment and end up having to pay BPMI, the good news is that you don’t have to pay it forever. In most cases, you can request to cancel your mortgage insurance policy once you have paid off more than 20% of the full loan amount. To quickly build equity in your home and get rid of mortgage insurance sooner than planned, you can make higher or more frequent mortgage payments. 

Learn more about mortgage insurance from Vaster 

Mortgage insurance is simply one key component of buying a home. It’s totally understandable that you may feel overwhelmed and underprepared for the mortgage process simply due to the sheer amount of costs, terms, conditions, etc. If you’re in need of additional guidance or expertise, feel free to reach out to the lending experts at Vaster Capital. We can help walk you through the lending process from application to closing. 

 

Sources:

What Is Mortgage Insurance? How It Works, When It's Required | NerdWallet

How Much Money Do I Need to Put Down on a Mortgage? | Investopedia

Loans and Mortgages - Components of a Mortgage Loan Payment | FDIC