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What Is Mortgage Insurance and How Does It Work?

When you can’t make your monthly mortgage payments, your lender stands to lose a lot of money. That’s where mortgage insurance (MI) enters the picture.

Mortgage insurance is an extra fee you pay that protects your lender if you can’t make payments. Not all loans require mortgage insurance but, generally, if you don’t make a sizable down payment to offset the risk to your lender, expect to pay this added expense.

What is mortgage insurance?

Mortgage insurance is a type of coverage that reimburses your lender for financial losses if you default on your loan. MI allows lenders to offer loans with lower minimum down payments which, in turn, helps cash-strapped homebuyers afford a home.

The cost of mortgage insurance is usually charged as part of your monthly payment, as a lump sum or a combination of both. Although the term mortgage insurance typically relates to conventional loans and mortgages insured by the Federal Housing Administration (FHA), you still pay a form of it for loans backed by the Department of Agriculture (USDA) and the Department of Veterans Affairs (VA).

Mortgage insurance is not to be confused with mortgage protection insurance, or mortgage life insurance, which pays your loan balance off if you die unexpectedly.

Different types of mortgage insurance

Private mortgage insurance

Private mortgage insurance (PMI) is typically required on conventional loans if you make less than a 20% down payment. Conventional loans are the most popular loan type with guidelines set by Fannie Mae and Freddie Mac, two government-sponsored enterprises that fuel the U.S. mortgage market.

Unlike other forms of mortgage insurance, you can get rid of PMI by asking your lender to cancel it once you gain 20% equity. By law, lenders must terminate PMI automatically once your loan-to-value (LTV) ratio falls to 78% of your home’s original value.

How much it is and when you pay it

PMI is always paid at closing and there are four ways to pay it:

  1. Monthly premium. The most common way to pay PMI is as part of your monthly mortgage payment.
  2. Single premium. The entire mortgage insurance premium is paid as a one-time expense at closing.
  3. Combination of monthly and single premiums. This may be called a “split premium” and allows you to pay a portion of PMI monthly and the rest upfront.
  4. Rolled into your interest rate. More commonly called lender-paid mortgage insurance, the lender pays your PMI fee upfront and charges you a slightly higher interest rate.

FHA mortgage insurance

FHA loans require two types of mortgage insurance regardless of your down payment amount.  The first is an upfront mortgage insurance premium (UFMIP) that’s usually rolled into your loan in one lump sum. The second is an annual mortgage insurance premium (MIP), which is included in your monthly mortgage payment.

How much it is and when you pay it

The UFMIP fee is 1.75% of the loan amount in most cases. Annual MIP ranges from 0.45% to 1.05% of the loan amount, depending on the repayment term and down payment amount. The premium is divided by 12 and paid as part of your monthly payment. FHA mortgage insurance is paid at your closing.

VA funding fee

The U.S. Department of Veterans Affairs (VA) guarantees loans made to military borrowers and offsets the cost of the program to taxpayers by charging a VA funding fee, regardless of your down payment amount. The funding fee acts like mortgage insurance, because it helps the VA recoup losses paid out on VA foreclosures.

If you default on a VA loan, your VA entitlement typically pays a lender up to $36,000 or 25% of the loan amount (up to the conforming loan limits).

How much it is and when you pay it

The funding fee ranges from 0.5% to 3.6% of the loan amount, depending on your down payment amount, loan type and how many times you’ve used your VA home loan benefits. The fee is paid at closing, either out of pocket or by the seller.

USDA guarantee fee

Lenders collect two types of guarantee fees on USDA loans: a lump-sum guarantee fee and an annual fee, regardless of down payment. No down payment is required for USDA loans, which are geared toward low- to moderate-income borrowers buying homes in USDA-designated rural areas.

How much it is and when you pay it

The upfront guarantee fee is 1% and usually added to the loan amount. However the fee is not paid in advance as the name might imply; it is payable all at once or “upfront,” rather than as an ongoing charge for the life of the loan. An annual, recurring guarantee fee of 0.35% of the USDA loan amount is divided by 12 and added to your monthly mortgage payment. Both fees are paid at closing.

How much is mortgage insurance?

Your down payment amount usually has the biggest impact on how much you pay for mortgage insurance. However, a low credit score can drive up PMI rates for a conventional mortgage.

The table below shows the MI cost based on different down payment amounts and credit scores for a $250,000 home purchase with a 30-year, fixed-rate mortgage term.

Type of mortgage insurance Down payment Credit score Mortgage insurance charge Loan amount Mortgage insurance payments
Conventional PMI 5% 740 0.53%*
1.73%**
$237,500 Monthly:
Single:
$104.90 $4,108.75
10% 0.38%*
1.16%**
$225,000 Monthly:
Single:
$71.25 $2,610.00
Conventional PMI 5% 640 1.33%*
3.91%**
$237,500 Monthly:
Single:
$263.23  $9,286.25
10% 0.91%*
2.65%**
$225,000 Monthly:
Single:
$170.63  $5,962.50
FHA MIP and UFMIP 3.5% No impact on MIP or UFMIP 0.85% MIP
01.75% UFMIP
$241,250 Monthly MIP:
UFMIP:
$170.89  $4,221.88
10% 0.80% MIP
01.75% UFMIP
$225,000 Monthly MIP: UFMIP: $150.00 $3,937.50
VA funding fee 0% No impact on funding fee 02.30%** $250,000 First-time use: $5,750.00
5% 01.65%** $237,500 First-time use: $3,918.75
USDA guarantee fee 0% No impact on guarantee fee 1.00% $250,000 Guarantee fee: $2,500
0.35% Annual fee (paid monthly): $72.92

Based on MGIC 2018 rates for borrower paid-monthly mortgage insurance. MGIC is a subsidiary of MGIC Investment Corporation, one of the largest PMI providers in the mortgage industry.*
Based on MGIC 2018 rates for single-premium mortgage insurance.** 

How to avoid (or reduce) mortgage insurance costs

Mortgage insurance costs can be pricey, but there are ways to minimize — and even eliminate — the expense altogether.

Private mortgage insurance

How to avoid it:
  • Make at least a 20% down payment. You can get a mortgage without PMI by making a down payment of at least 20%.
  • Take out a piggyback loan. Rather than paying mortgage insurance, you can take out a home equity loan or home equity line of credit (HELOC) and “piggyback” it on top of your first mortgage. In most cases, you’ll need a 10% down payment for the 80-10-10 loan, which is the most common piggyback option. Here’s how it works:
    • Borrow 80% of the home’s value as a first mortgage
    • Borrow 10% of the home’s value as a home equity loan or HELOC
    • Make a 10% down payment on your next home
How to keep the cost low:
  • Boost your credit scores. Your credit score plays a big role in your PMI costs; keeping low credit card balances and paying on time could mean big savings.
  • Ask the seller to pay lump sum PMI. Consider using a seller concession to buy out your PMI costs with lump sum PMI. You might end up needing cash for the other costs, but will have a lower monthly mortgage payment.
  • Choose lender-paid mortgage insurance. Taking a higher interest rate so your lender pays your mortgage insurance upfront may keep your out-of-pocket costs low at the closing table. However, you’re stuck with the higher rate for the life of the loan.
  • Check your home equity regularly. You can ask to cancel PMI once you’ve reached 20% equity. You might have to pay for a home appraisal, but it’s worth it if home prices are booming in your neighborhood.
  • Buy a single-family home. You’ll get the lowest premium for a single-family home; condos, co-ops, multifamily and manufactured homes cost more.
  • Keep your debt-to-income (DTI) ratio low. A DTI of more than 45% usually comes with a higher PMI premium.
  • Choose a shorter loan term and a fixed interest rate. You’ll shell out more PMI dollars for a term of 20 years or more, or if you get an adjustable-rate mortgage (ARM).

FHA MIP & UFMIP

How to avoid it:

The only way to avoid FHA MIP and UFMIP is to choose a different loan type.

How to keep the cost low:
  • Make at least a 10% down payment. The annual MIP is slightly lower with at least a 5% down payment, and it will drop off after 11 years.
  • Choose a shorter loan term. If you can afford the payments of a 15-year mortgage term, it will reduce your monthly MIP premium.
  • Refinance to a conventional loan as soon as you can. If you chose an FHA loan because your credit scores were low, refinance your FHA loan to a conventional mortgage as soon as your credit is in better shape to refinance and get rid of PMI costs.
  • Ask the seller to pay the UFMIP. The FHA permits sellers to pay up to 6% of your sales price to cover FHA closing costs, including your UFMIP.
  • Do an FHA streamline refinance. If you currently have an FHA loan, the FHA streamline refinance allows you to refi with reduced MIP costs. An added bonus: You don’t need income documents or an appraisal.

VA funding fee

How to avoid it:

Apply for a VA disability waiver. Military veterans with a service-related disability may be eligible for a funding fee exemption. Find out if you’re exempt by obtaining your VA certificate of eligibility.

How to keep the cost low:
  • Make a bigger down payment. A down payment of 5% to 10% may save you thousands of dollars on the funding fee.
  • Ask the seller to pay the funding fee. VA guidelines allow sellers to pay up to 4% of the sales price toward the buyer’s VA closing costs.
  • Save your VA home benefits for your dream home. The VA funding fee is 2.3% of your loan amount the first time you use it compared to 3.6% for every use thereafter. On a $300,000 loan, for example, you’ll save an extra $3,900 on the fee if you use your VA eligibility for the first time.

USDA guarantee fees

How to avoid it:

The only way to avoid USDA guarantee fees is to choose a different loan program. However, the current USDA fees are significantly lower than they were prior to October 2016. The upfront guarantee fee was reduced from 2.75% to 1%, while the annual fee dropped from .5% to .35%.

 

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