What Is Mortgage Insurance and How to Avoid

What Is Mortgage Insurance and How to Avoid

Mortgage insurance is an annoying charge some first time home buyers might see as part of their payment. It can eat into your budget and make homes less affordable. Getting out of it is possible but requires a larger down payment. We all know why a mortgage is needed, but rarely do we think about what happens if the mortgage cannot be paid off due to unplanned events. That's why mortgage insurance exists. What is mortgage insurance used for? How does it work? What does mortgage insurance cover? How can you avoid paying for mortgage insurance? These and other questions related to mortgage insurance will be answered in this article.

What Is Mortgage Insurance?

Mortgage insurance is an insurance policy that protects the mortgage lender or title holder if the borrower (that’s you) defaults, dies, or is otherwise unable to meet the mortgage's contractual obligations.

Note - this is insurance the home buyer purchases that protects the lender. Seems a little odd in terms of who is paying doesn’t it?

How Does Mortgage Insurance Work?

Mortgage insurance is an extra fee you pay on your mortgage to insure against you defaulting on the loan. It can be as little as 0.25% to as high as 2.5% depending on the size of the loan and your credit. The bigger the loan and the lower your credit score the higher the PMI.

Mortgage insurance is typically a pay-as-you-go premium payment included in your monthly bill. In some cases it may be capitalized into a lump-sum payment at the time of mortgage origination. 

For homeowners who are required to have PMI because of the 80% loan-to-value ratio rule, they can request that the insurance policy be canceled once 20% of the principal balance has been paid off. 

What Does Mortgage Insurance Cover?

Mortgage insurance is not for the benefit of the borrower but for the benefit of the lender. This insurance protects your mortgage company from loss if you are unable to make your payments. This insurance will not protect you from losing your home if you default on the loan.

In order to cover yourself you can look into short term disability, long term disability, or different levels of mortgage payment protection insurance depending on what you want to be covered for.

  • Accidents and illness - if you are unable to work due to serious illness or injury this can cover your mortgage repayments.
  • Unemployment - if you lose your job due to “no fault of your own” unemployment will replace a portion of your income for a short time. However unemployment is not paid for accidents or illnesses.

The best way to protect yourself from defaulting on your mortgage is to setup an emergency fund. It is frustrating that when buying a home you need a large down payment, you need to pay the mortgage each month (which may be more than what you are paying in rent), AND the day you move in you are on the hook for maintenance, unexpected repairs, etc.

How Much Is Mortgage Insurance and how is it calculated?

What you pay for mortgage insurance depends mainly on the size of your loan. Typically the cost is from 0.25% to 2.5% of the loan amount per year. Mortgage insurance is always calculated as a percentage of the mortgage loan amount. This amount is not based on the appraised value of the home or the purchase price.

For example, if you take out a $300,000 loan, and the PMI was 1.5% it would cost $4,500 per year or $375 per month. Your actual PMI rate will depend on the size of your loan, credit score, down payment, and debt-to-income ratio.

Another example - if your loan is $200,000 and the annual mortgage insurance is 1%, you would pay $2,000 in mortgage insurance that year, and $166 per month.

Since mortgage insurance is calculated each year, your PMI will decrease as you pay off the loan each year.

When Does Mortgage Insurance Go Away?

The Homeowners Protection Act of 1998 requires lenders to terminate private mortgage insurance when a borrower reaches a 78% loan-to-value (LTV) ratio. If the purchase price of your home was $300,000 and would reach a 78% LTV ratio when your balance hits $234,000. After that, your PMI is calculated again, and the amount you pay decreases as you pay off the loan until the PMI is eliminated!

How To Get Rid of Mortgage Insurance

There are three ways to get rid of mortgage insurance.

  1. Submit a request for termination of PMI. You can do this if the loan has met certain conditions and if your loan-to-value ratio is below 80%, then you can file a PMI cancellation request with your mortgage servicer.
  2. Getting a new home appraisal - it may happen that the value of your home has changed due to renovations and before you get a new home appraisal and before you decide to get a new home appraisal check with your lender about the rules or requirements before they order a new home appraisal.
  3. Refinance - if your home has grown significantly in value this may be a good time to refinance and lower your payment. If rates have dropped this can be a good option anyway. However if rates have increased, eliminating PMI may not be beneficial enough to offset the new higher interest rates.

How To Avoid Mortgage Insurance

If you want to avoid PMI, you need to have at least a 20% cash down payment for the purchase of a house.

Conclusion: Mortgage insurance sucks and getting rid of it ASAP will save your money each month. Once you get below 78% LTV it will go away automatically but you can cancel it sooner if you are proactive.

The post What Is Mortgage Insurance and How to Avoid is part of a series on personal finances and financial literacy published at Wealth Meta. This entry was posted in Homes and Real Estate
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