No matter how carefully you budget for a home, or how far ahead you plan your finances, there’s a chance you’ll fall behind on your mortgage payments. Accordingly, mortgages are sometimes significant risks to lenders, and it’s important for them to protect their investments.
This is the main reason mortgage insurance exists. It’s designed as a way for lenders to mitigate their risks when loaning money to consumers to purchase homes — but realistically, mortgage insurance offers some interesting benefits to borrowers as well.
So how, exactly, does mortgage insurance work, and who should get it?
The basic idea
Most types of mortgage insurance function similarly; in an effort to mitigate risk, the lender requires the consumer to pay an additional rate each month (typically a percentage of the original loan amount). Should the consumer fail to continue making payments, the lender can tap the insurance policy to cover any losses they would face from non-payment.
Who really needs mortgage insurance?
In some cases, mortgage insurance is a requirement. So who actually “needs” mortgage insurance?
- Conventional borrowers. Many lenders require borrowers to get private mortgage insurance (PMI) to complete the loan if they fail to meet certain requirements. For example, if your down payment is less than 20 percent of the total price of the home, you may be required to pay PMI. PMI fees vary significantly, depending on your personal circumstances, but generally fall between 0.3 percent and 1.5 percent of the loan amount, per year.
- FHA borrowers. If you get a Federal Housing Administration (FHA) loan, you’ll probably be required to pay insurance premiums to the FHA, though this isn’t always a requirement. If your down payment is less than 5 percent, you may be required to pay a bit more. There will be fees due at closing and as part of your monthly payments.
- USDA borrowers. If you get a US Department of Agriculture (USDA) loan, you’ll also be required to pay insurance premiums, but the premiums are cheaper. Like with FHA loans, there will be fees due at closing and as part of your monthly payments.
Beyond these circumstances, mortgage insurance is mostly optional.
Two types of mortgage insurance
There are two main types of mortgage insurance to consider:
- Borrower-paid insurance. Borrower-paid insurance is the most common type of mortgage insurance required. It can be paid monthly or as a single upfront premium, and can help borrowers qualify for a loan with a smaller down payment.
- Lender-paid insurance. Lender-paid insurance doesn’t have any monthly payments, but instead offers the buyer a higher interest rate, and possibly a higher closing fee.
Benefits of mortgage insurance
Why would you get mortgage insurance if you don’t have to? There are some benefits for borrowers. For example, if you’re struggling with qualifying for a standard mortgage, opting for mortgage insurance could help you get what you need. If you want to buy a home as soon as possible, but can’t currently afford a 20% down payment, mortgage insurance can also help you get a loan faster.
It’s also worth considering that it’s possible to remove PMI from your loan after a fixed amount of time, or after certain circumstances are met. For example, if you gain significantly more equity in your home, or if your credit score improves past a certain threshold, you may be able to reduce your monthly payments by having the mortgage insurance removed (though this is usually relegated to PMI).
Should you buy mortgage insurance?
So is it a good idea to buy mortgage insurance? If you’re trying to qualify for a government-sponsored program, you probably won’t have a choice, and if you’re offering a down payment of less than 20%, you’ll be forced to enroll as well.
If it is your choice, you should know that there are some benefits to having mortgage insurance — namely, the ability to buy a home faster — but you’ll also be paying an extra fee. Ultimately, mortgage insurance is designed to protect the interest of the lender, so for most consumers, it’s not worth getting unless it’s going to significantly improve your home purchasing decision.
Disclosure: I do not own any of the stocks mentioned in this article.
