What is mortgage insurance?
A common question I get from borrowers is, “What is mortgage insurance, and why do I need it?” The easy answer is that mortgage insurance is an insurance policy that the lender forces you to buy that protects them from losses on the mortgage note should your loan go into foreclosure. Mortgage insurance is required on all loans that exceed 80% loan to value (LTV). In the case of FHA loans, mortgage insurance is required on all loans, regardless of loan to value, unless the term is 15 years or less. I’ll talk more about this later. There are different variations of mortgage insurance, and based on your particular situation one type may be better than the next. Because of this your mortgage broker must approach the question with your particular situation in mind and think it through.
What is mortgage insurance?
One type of mortgage insurance is Private Mortgage Insurance, otherwise known as PMI. PMI is an insurance product underwritten by private corporations; it has stringent qualifying criteria and is more expensive than FHA mortgage insurance. At one point in time PMI was unavailable if the LTV exceeded 90% in what was described as declining markets. Declining markets were defined by the mortgage insurance companies and if you exceeded the LTV threshold and happened to have a home in one of those areas you were out of luck. PMI has debt to income (DTI) restrictions and credit rating restrictions as well. For instance, if your DTI exceeds 41% then you are ineligible to receive PMI. DTI is a calculation of your monthly debts that show on your credit report, including mortgage payment, hazard insurance, property taxes, and mortgage insurance compared to your gross monthly income. Let’s assume that your monthly gross income is $1000 and your monthly debts, as outlined above, are $500 then your DTI would be 50%. PMI credit rating restrictions have loosened up recently, but it wasn’t uncommon to find that if your credit rating was below 680 then you couldn’t get PMI on higher LTV’s. See my article here regarding credit scores and how to keep them up. Radian, a mortgage insurance company, has an online calculator where you can figure out what mortgage insurance will cost you monthly. Here’s a hyperlink to Radian’s mortgage insurance calculator.
The second type of mortgage insurance is guaranteed by the government and it comes in the form of an FHA loan. FHA stands for Federal Housing Administration and is actually an arm of the Department of Housing and Urban Development (HUD). FHA loans are beneficial to a large group of people. FHA loans were originally developed to aid the housing market during the great depression. FHA loans work well for people who have lower credit scores and don’t have a great down payment. Currently the down payment needed to acquire a FHA loan is only 3.5%. There are many benefits to a FHA loan compared to a conventional loan which I’ll write some other time. One benefit of a FHA mortgage is that the borrower can exceed the 41% maximum DTI calculation that exists with PMI. The monthly mortgage insurance premium that is paid on a FHA loan is typically less than that of private mortgage insurance, but FHA requires a onetime up front mortgage insurance premium (UFMIP) payment of 1% of the loan amount. The monthly mortgage insurance premium is where the FHA loan really excels. It’s calculated as an annual percentage rate actually, and it varies depending on the length of the loan term and the loan to value. If you’re interested just give me a ring or shoot me an email and I’ll give you all the details. If you take a loan with a term 15 years or less and the loan to value is equal to, or less than 78%, then there is no annual premium, meaning that you won’t have a monthly mortgage insurance payment. Now that’s cool!
The third type of mortgage insurance is actually a lender paid mortgage insurance (LPMI) and closely resembles PMI. It’s actually still provided by a mortgage insurance company, but instead of the borrower paying a monthly mortgage insurance premium, the cost is actually calculated into the interest rate. Let’s say that you qualify for an interest rate of 3.25% on a 30 fixed mortgage, but your LTV exceeds 80%. For the purposes of this scenario let’s say that if the borrower had PMI on this loan the monthly payment would be $200 for the mortgage insurance. If you chose to go with LPMI instead of PMI your rate may jump to 3.75% as a result, but you would knock off the $200 that you would pay in a monthly mortgage insurance premium. You can see that you’re still paying for mortgage insurance, but it’s factored into the rate instead of a separate monthly payment. This type of mortgage insurance will still usually have the same restrictions as PMI, but the payment could be less depending on your specific situation. The downside to LPMI is that you can never have it removed from the loan because it’s calculated into the interest rate for the entirety of the note term. The only way to get rid of LPMI is to pay off the existing loan via refinance or sale of the home.
So, what is mortgage insurance you ask? As you can see it’s not just a straightforward answer, and as always, one size does not fit all. It’s very important when sitting down with a mortgage professional that he/she understands the complexities of the market and puts together a plan that meets your needs and desires. Everybody doesn’t have the same situation and what may be right for you is not necessarily right for me. I hope this helps clear up some of the questions you may have regarding mortgage insurance and the place it has in our mortgage market.