What Is Mortgage Insurance and How Does It Work?
What Is Mortgage Insurance and How Does It Work?

Buying a home is one of the most important transactions, you will ever make and insurance can cover your property and legal liability. And you may be reviewing insurance options such as mortgage insurance and home insurance. But do you know exactly what it is?

Let us tell you about the benefits of buying mortgage insurance with an insurance company.

What Is Mortgage Insurance?

Mortgage insurance is an insurance policy that protects a mortgage lender or titleholder if the borrower defaults on payments, passes away, or is otherwise unable to meet the contractual obligations of the mortgage. Mortgage insurance can refer to private mortgage insurance (PMI), qualified mortgage insurance premium (MIP) insurance or mortgage title insurance. What these have in common is an obligation to make the lender or property holder whole in the event of specific cases of loss.

Mortgage life insurance, on the other hand, which sounds similar, is designed to protect heirs if the borrower dies while owing mortgage payments. It may pay off either the lender or the heirs, depending on the terms of the policy.

What Is Private Mortgage Insurance (PMI)?

Private mortgage insurance (PMI) is a type of insurance that a borrower might be required to buy as a condition of a conventional mortgage loan. Most lenders require PMI when a homebuyer makes a down payment of less than 20% of the home's purchase price.

When a borrower makes a down payment of less than 20% of the property's value, the mortgage's loan-to-value (LTV) ratio is over 80% (the higher the LTV ratio, the higher the risk profile of the mortgage for the lender).

Unlike most types of insurance, the policy protects the lender's investment in the home, not the individual purchasing the insurance (the borrower). However, PMI makes it possible for some people to become homeowners sooner. For individuals who elect to put down between 5% to 19.99% of the residence's cost, PMI allows them the possibility of obtaining financing.

However, it comes with additional monthly costs. Borrowers must pay their PMI until they have accumulated enough equity in the home that the lender no longer considers them high-risk.

PMI costs can range from 0.25% to 2% of your loan balance per year, depending on the size of the down payment and mortgage, the loan term, and the borrower's credit score. The greater your risk factors, the higher the rate you'll pay. And because PMI is a percentage of the mortgage amount, the more you borrow, the more PMI you’ll pay. There are several major PMI companies in the United States. They charge similar rates, which are adjusted annually.

While PMI is an added expense, so is continuing to spend money on rent and possibly missing out on market appreciation as you wait to save up a larger down payment. However, there's no guarantee you'll come out ahead buying a home later rather than sooner, so the value of paying PMI is worth considering.

Some potential homeowners may need to consider Federal Housing Administration (FHA) mortgage insurance. However, that only applies if you qualify for a Federal Housing Administration loan (FHA loan).

What Is Qualified Mortgage Insurance Premium (MIP)?

When you get a U.S. Federal Housing Administration (FHA)-backed mortgage, you will be required to pay a qualified mortgage insurance premium, which provides a similar type of insurance. MIPs have different rules, including that everyone who has an FHA mortgage must buy this type of insurance, regardless of the size of their down payment.

How Mortgage Insurance Works?

Photo: Experian
Photo: Experian

Mortgage insurance may come with a typical pay-as-you-go premium payment, or 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. Here are three types of mortgage insurance:

Private Mortgage Insurance (PMI)

Private mortgage insurance (PMI) is a type of mortgage insurance a borrower might be required to buy as a condition of a conventional mortgage loan. Like other kinds of mortgage insurance, PMI protects the lender, not the borrower. The lender arranges PMI and it's provided by private insurance companies.

PMI is usually required if a borrower gets a conventional loan with a down payment of less than 20%. A lender might also require PMI if a borrower is refinancing with a conventional loan, and equity is less than 20% of home value.

Qualified Mortgage Insurance Premium (MIP)

When you get a U.S. Federal Housing Administration (FHA)-backed mortgage, you will be required to pay a qualified mortgage insurance premium, which provides a similar type of insurance. MIPs have different rules, including that everyone who has an FHA mortgage must buy this type of insurance, regardless of the size of their down payment.

Mortgage Title Insurance

Mortgage title insurance protects against loss in the event a sale is later invalidated because of a problem with the title. Mortgage title insurance protects a beneficiary against losses if it is determined at the time of the sale that someone other than the seller owns the property.

Before mortgage closing, a representative, such as a lawyer or a title company employee, performs a title search. The process is designed to uncover any liens placed on the property that would prevent the owner from selling. A title search also verifies that the real estate being sold belongs to the seller. Despite a thorough search, it isn’t hard to miss important pieces of evidence when information is not centralized.

Mortgage Protection Life Insurance

Borrowers are often offered mortgage protection life insurance when they fill out paperwork to start a mortgage. A borrower can decline this insurance when it is offered, but you may be required to sign a series of forms and waivers, verifying your decision. This extra paperwork intends to prove you understand the risks associated with having a mortgage.

Payouts for mortgage life insurance can be either declining-term (the payout drops as the mortgage balance drops) or level, although the latter costs more. The recipient of the payments can be either the lender or the heirs of the borrower, depending on the terms of the policy.

What Are The Benefits of Mortgage Insurance?

Photo: KnowInsiders
Photo: KnowInsiders

These days, you can buy mortgage insurance from a bank when signing your mortgage or you can buy it from a financial institution. To help you decide, here are the advantages of buying your mortgage insurance from a financial institution:

You own the contract and choose your beneficiaries

When you buy mortgage insurance from your bank, the bank owns the contract and is the beneficiary. If you buy your mortgage insurance from an insurance company, you own the contract and can name any beneficiary you want. Your beneficiary can choose to repay the loan, pay his or her debts or use the benefit for something else.

Your premium is fixed and guaranteed

The amount of mortgage insurance coverage you buy from an insurance company will remain the same for the duration of the loan… For example, you have a $200,000 mortgage and buy $200,000 in coverage that you will keep year after year. At a bank, the amount of your mortgage insurance coverage will decrease as the balance of your mortgage decreases while your premium will remain the same.

You can convert your mortgage insurance

An insurance company will allow you to convert your mortgage insurance to permanent life insurance, as needed, throughout the term of your loan. If you do convert your insurance, your premium will not increase and you will not have to undergo a medical exam. The policy will remain in force until your death.

No more shopping around

By buying your mortgage insurance from an insurance company, you won’t have to shop around for mortgage insurance for the duration of the term. Additionally, the cost will not increase over the years. If you buy from a bank, you are required to negotiate new mortgage insurance and your premium will be higher based on your age and any changes to your health in the meantime.

How Will You Pay For Mortgage Insurance?

If you have a mortgage, you will generally pay your monthly mortgage payments. Mortgage lenders pay the premiums for you and incorporate the cost into your mortgage payments. The money will typically go into an escrow account before it's distributed to the insurance company.

Conversely, mortgage insurance payments can come in a variety of forms:

  • Conventional loans: When the mortgage isn't guaranteed or insured by the federal government, a lender will typically require you to pay private mortgage insurance. PMI can be baked into your premium or paid in one lump sum at closing. You can ask your lender to cancel your PMI when you've reached a loan-to-value ratio of 80%.
  • FHA loan: If your mortgage is insured by the Federal Housing Administration, you'll pay two forms of mortgage insurance: an upfront premium and a monthly payment (baked into the premium). FHA loans are suited for borrowers who want to make low down payments (starting at 3.5%) or have lower credit scores. The mortgage insurance covers the risks associated with this type of loan.

What Are Differences Between Home Insurance Vs. Mortgage Insurance?

Photo: KnowInsiders
Photo: KnowInsiders

Homeowners insurance pays you if there’s theft or damage to your property (house or possessions). By contrast, mortgage insurance pays your lender if you default on the loan. If you can’t make mortgage payments, the mortgage insurer will make sure the lender receives the balance.

What does it cover? Who does it cover? Who is it required to have it?

Homeowners insurance

Your house and belongings against damage and theft. It also includes liability insurance, medical payments coverage, and loss of use coverage.

The homeowner

Borrowers who finance the purchase of a home

Mortgage insurance

If you default on your mortgage, the insurance policy guarantees the insurer will pay the lender the mortgage balance.

The lender

Borrowers who put less than 20% down on a home

Home Insurance vs. Mortgage Insurance: Lender Requirements

If you have a mortgage, the type of insurance you’re required to have depended on how you pay for the home.

Homeowners insurance purchase requirements. If you financed the property, lenders generally will require you to have homeowners insurance before they fund the loan. Since lenders have a financial interest in your property, they want to ensure it’s protected if something like a fire were to destroy it.

Even after you repay your mortgage, it’s wise to maintain your homeowner's insurance policy. While it’s not a requirement at this point, the policy will protect you from financial loss if something happens to your home or belongings.

Mortgage insurance purchase requirements. While you may be required to purchase homeowners insurance, you can usually avoid mortgage insurance if you put down 20% or more of the property’s appraised value.

A lender will require different types of mortgage insurance depending on the type of loan you apply for. For example, conventional loans could require that you purchase private mortgage insurance (PMI) if you put less than 20% down.

With conventional loans, you can generally cancel your PMI once you reach 20% equity. Check with the lender to verify how long you must keep PMI and how to request cancellation.

Federal Housing Administration (FHA) loans require only a 3.5% down payment, but you’ll need to pay for mortgage insurance for the entirety of the loan if you put less than 10% down. If you put more than 10% down, you can cancel your mortgage insurance premium (MIP) after 11 years.

Home Insurance Vs. Mortgage Insurance Payments

Home insurance payments: Payments for homeowners insurance and mortgage are sometimes bundled into a single payment. Some lenders require you to have an escrow account. Your lender typically collects the funds as part of the mortgage payment, puts the funds in the escrow account, and then pays your home insurance company on your behalf. By using an escrow account, the lender can ensure home insurance is paid for on time.

Mortgage insurance payments: Your loan type will determine how you make your mortgage insurance payments. If you have to buy PMI, the lender may let you choose an upfront payment or monthly payments added to your mortgage.

FHA loans require you to pay an upfront MIP and an annual fee included in your monthly payment.

What is Homeowners Insurance?

Homeowners insurance protects you from financially devastating losses if your home’s structure, detached structures on your property, and your personal belongings are damaged or destroyed from hazards like fires or storms. Without homeowners insurance, you would have to pay to rebuild your home or replace all your belongings yourself, which could be financially devastating.

Even in rare cases where your lender does not require you to have home insurance or if your home’s mortgage is paid off, it is a prudent financial decision to have protection through insurance. The insurance premium is small compared to the cost of repairing or replacing a home and belongings in case of a loss.

Consult with a trusted insurance professional to help buy the right amount of homeowners coverage for the best price to provide you and your family with financial peace of mind.

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