What is Mortgage Insurance and How Does It Work?

by Michael Mapes, The Resonsible Mortgage Lender.Com  

Mortgage lenders stand to lose a lot of money when a borrower defaults on a loan.  Mortgage Insurance was created to protect lenders from the losses that can occur when a borrower defaults on a mortgage loan. Because lenders can be insured for some or most of the losses, they have been able to loosen their qualification standards for borrowers and loan money to people who might not have gotten it if mortgage insurance didn't exist.

Mortgage insurance is required primarily when the borrower's down payment is less than 20% of the home's value.  Mortgage Insurance should not be confused with homeowner's insurance which pays the homeowner for property and contents losses in the case of accidents, fire and natural disasters. Nor should it be confused with mortgage life insurance which pays off the balance of a borrower's mortgage in the event of the borrower's death.

Different types of loans have different types of mortgage insurance.  Private Mortgage Insurance (PMI) applies to conventional loans (loans not guaranteed by the government) and is based on many factors including how much is being borrowed and the borrower's credit score.  A Mortgage Insurance Premium (MIP) applies to FHA loans which are back by the federal government.  PMI is a set rate of .0045% of the amount borrowed. The VA funding fee is a form of mortgage insurance (though technically it's a guarantee) for Veteran's Administration guaranteed loans.    

Conventional Loans  

Traditionally, borrowers made a 20% down payment when purchasing a home. That down payment was enough to provide the lender with sufficient equity to recoup their losses in the event the borrower defaulted on the loan. The lender would foreclose on the home, resell it and the loss would be minimized by the 20% equity put down when the home was purchased.

However, since many people are not able to make a 20% down payment, lenders developed an alternate means of providing home ownership with a lower down payment: Mortgage Insurance. The mortgage insurer protects the lender against a portion of the loss in a defaulted mortgage, thereby reducing the lender's risk to an acceptable level. There are several private mortgage insurers in the industry. Although the lender usually coordinates the process of obtaining mortgage insurance, the borrower may select the mortgage insurer if they wish. Mortgage insurance rates are regulated, so the lender's choice of an insurer should not have any impact on the premium.  (PMI Is required by Law, when the first mortgage lien is in excess of 80% of the purchase price or appraised value for refinances)  A borrower with any insurance policy is required to pay a premium, think of it as your car insurance.  Instead of it paying when you have an accident PMI pays the lender for any financial loss should you stop paying and foreclosure take place.  Do not confuse this that the borrower gets away free of any debt.  The borrower is on the hook for the difference between what was owed and what was received when the house sold plus any expenses like attorney fees, inspections, etc.)

In most cases today, Mortgage Insurance isn't necessary if you have a down payment of 20% or more.  As your down payment goes down your mortgage insurance goes up. However, there are many alternative programs that eliminate the need for mortgage insurance, even with very small down payments. These "No Mortgage Insurance Loans" or "No MI Loans" are usually a financially superior decision.  Two of the most common loan types are FHA loans and VA loans.  

FHA Loans

The FHA (Federal Housing Administration) provides loans to borrowers with very low down payments. The concept is similar to conventional loans, with a few exceptions. The insurance dollars are paid by the borrower to the FHA. An up-front premium is due at loan closing, and that premium may be included in the loan amount and paid over the course of the loan. A monthly insurance premium varies with the term of the loan and the loan-to-value ratio.  

VA Loans

The Veteran's Administration makes available loans to qualified veterans with no down payment. A funding fee is paid at the time of closing and the fee may be included in the loan amount. There is no monthly insurance on a VA loan. The amount of the funding fee is set by the Veterans Administration and varies from 0%(for disabled veterans) to 3% for each time used after the first.

In short, mortgage insurance provides lenders with a safety net so that they may continue to provide affordable loans for affordable housing.  How much insurance you pay depends on the type of loan you get.  When talking with your mortgage banker, be sure to ask about mortgage insurance and how it applies to you.

Michael Mapes can be reached at 757.599.1810 ext 225 or on the web at www.theresponsiblemortgagelender.com