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Mortgage Insurance: What it is and how it works

Homeownership will likely always be the American dream, but intense demand and limited supply makes the realization of that dream an expensive proposition for many people. Asking prices on residential properties of all types keep climbing, as the median existing-home costs over $266,300, according to the most recent statistics available from the National Association of Realtors. With expenses tight and financial responsibilities ongoing, homeownership may seem like it's out of reach.

Through mortgage insurance, however, it doesn't have to be. If you're considering buying a home but know you likely can't afford a 20% down payment, mortgage insurance can bridge the divide and make homeownership eminently achievable.

What is the purpose of mortgage insurance?

One of the biggest misconceptions about buying a home that exists to this day, is the notion that you must pay 20% of a home's listed price to be approved for a loan. Nothing could be further from the truth. If that were the case, a $266,300 house would require a down payment of over $53,000 - an amount many would be hard-pressed to come up with. 

In reality, substantial down payments such as these aren't necessary. A mortgage insurance policy is something lenders generally require borrowers to purchase when their down payments are less than 20% of the purchase price. With down payments averaging roughly 7% among first-time buyers these days, based on the most recent figures available from NAR, mortgage insurance kills two birds with one stone.

First and foremost, it provides lenders with the security they need to ensure they'll be paid back if the borrower is unable to pay off the loan in full. In doing so, borrowers are able to consider more potential places to purchase because the policy gives them more buying power. Using the previous example, a 7% down payment on a home costing the national median house would be just $18,641 with mortgage insurance in place. That equates to a savings of over $34,600 compared with putting 20% down.

How does mortgage insurance work in practice?

As you're no doubt already aware, most people with mortgages pay them off in installments, typically once every month. The interest on a home loan is worked into the price paid every time they make a payment, as are property taxes and homeowners insurance if applicable. Mortgage insurance works in a similar fashion, in that the premium is factored into your monthly payment.

There may be slight variations in payment structure depending on the loan you choose. For example, one of the more popular mortgage products in the market today is backed by the Federal Housing Administration; these are better known as FHA loans. Perhaps the most distinguishing characteristic of such products - aside from their flexible terms and competitive interest rates - is how mortgage insurance premiums are paid.

For the most part, though, private mortgage insurance is structured in one of four ways: (1) single premium, (2) monthly, (3) split and (4) lender paid:

  • (1) A one-time fee that is paid at closing.
  • (2) Added to the mortgage payment (most popular).
  • (3) Portion paid at closing and remainder worked into monthly payment (least popular).
  • (4) Lender pays by applying additional interest on the loan paid by the borrower.

There is no right or wrong answer to which one you select. It all depends on your financial situation and most effectively aligns with your budget. 

Do veterans pay mortgage insurance?

Another attractive mortgage offering that entails unique insurance rules is a VA loan from the U.S. Department of Veteran Affairs. Naturally, these are only available to those on active duty and veterans of the armed forces.

Men and women eligible for VA loans are not required to come with a down payment. Since it isn't necessary, that would suggest mortgage insurance isn't mandatory either, right? Not exactly.

In lieu of it, veterans and active-duty service members pay what might be best described as a funding fee. The fee that gets bundled into the overall monthly loan balance depends on a number of factors. These may include - but aren't limited to - whether the applicant has taken out a VA loan previously and if they'd like to make a down payment to reduce their monthly payments, according to Nerdwallet.

Do you need mortgage insurance for as long as you're making loan payments?

This is another question that doesn't have a quick and easy answer. It all depends on your situation and the type of loan you select. Take FHA loans as a classic example. With this government-backed loan, mortgage insurance is required for the life of the loan, which generally means you'll be making payments for 15 years to 30 years.

However, in other instances, you may be able to cancel the policy based on your consistency of making payments before the deadline or whether your house has gained equity, or value. As the balance on the loan continues to decrease with regular payments, the equity increases. As little as 20% equity can be enough to stop spending money on monthly mortgage insurance  payments. A textbook definition of "equity rich" is when the original loan amount is 50% or less of the house's market valuation. In the closing quarter of 2019, of the approximately 54.5 million existing-homes in the U.S., roughly 27% were equity rich, according to ATTOM Data Solutions.

Usually, MI payments are canceled automatically when the principal balance drops to 78% and equity reaches 22%. However, you may be able to cancel once the equity hits the 20% milestone. Talk to your lender to see if this can be arranged.

Some view mortgage insurance as an obligation. In reality, it's an opportunity to broaden your financing options and purchase a home that may otherwise be beyond your budget. Contact Residential Mortgage Services to learn more.