If you're a first-time homebuyer, you're probably going to run into something called mortgage insurance, often referred to as PMI. It's required on most mortgages if you make a down payment of less than 20 percent of the price of the home.
Though you can't shop around for mortgage insurance like you would for homeowner's insurance, you do have options available to you. Some of the choices you make regarding a home loan will have a significant effect on what you pay for mortgage insurance, so it's important to know what those options are and to have a basic understanding of mortgage insurance overall.
What mortgage insurance does
As noted above, mortgage insurance is generally required on mortgages with less than 20 percent down. A down payment of 20 percent or more gives a lender a cushion in the event of a default - if the loan goes into foreclosure, the lender has at least that much to cover the costs of repossession and selling the property at what will likely be a reduced price.
Mortgage insurance covers the difference between your actual down payment and the 20 percent figure. So if you put 10 percent down and default on the loan, the mortgage insurance will kick in another 10 percent so the lender still gets its full 20 percent cushion. If you put 5 percent down, the mortgage insurance will pay an amount equal to 15 percent of the home's price in the event of default.
You'll note that mortgage insurance doesn't pay off the entire mortgage and it doesn't pay you - the lender is the beneficiary. But what it does is provide the lender with the same level of security as a 20 percent down payment.
Do all loans require mortgage insurance?
As noted above, you don't need mortgage insurance if you put down 20 percent or more when buying a home, OR if you have at least 20 percent home equity when refinancing.
Nor is mortgage insurance required on a VA loan or USDA Rural Development Loan. On those home loans, the role of mortgage insurance is covered by the U.S. government. Of course, eligibility for those loans is limited - VA loans to veterans and others with certain military affiliations, and USDA loans to those of low-to-moderate incomes who currently lack adequate housing.
You do have to pay for mortgage insurance if you put less than 20 percent down on a conventional mortgage - one backed by either Fannie Mae or Freddie Mac - or an FHA home loan. Those three types account for the great majority of mortgages in this country.
Types of mortgage insurance
Although mortgage insurance is often referred to as PMI, that's really only one type of coverage. PMI stands for Private Mortgage Insurance and is the type of mortgage insurance most commonly used with Fannie/Freddie conventional mortgages. You pay a monthly premium that's added onto your regular mortgage statement and which is based on a certain annual percentage of your mortgage amount.
A less-common option is LPMI, which stands for lender-paid mortgage insurance. In this case, the lender pays the annual premium for you, but covers the cost by charging you a higher mortgage rate. So you're still paying for it in the end. Another possibility is to pay a single premium up front at the time you take out the mortgage, but few borrowers choose this option.
FHA home loans have their own coverage, known simply as FHA mortgage insurance. You pay a single premium at the time you take out the loan (currently 1.75 percent of the amount borrowed) and then additional monthly premiums from then on.
PMI is the most common type of mortgage insurance, so we'll address that first. The cost will vary based on both the size of your down payment and your credit score - smaller down payments and lower credit scores mean higher premiums. You'll also pay higher premiums for a second home or investment property than you would on a primary residence (other adjustments may apply as well).
For most borrowers, the cost of PMI on a 30-year fixed-rate mortgage will be an annual premium ranging from 0.3-0.9 percent of the loan amount, billed as a monthly fee added onto the mortgage statement. Those premiums may be higher for high-value homes (jumbo loans), manufactured homes, cash-out refinancing, second homes, investment property and down payments of less than 5 percent.
One of the nice things about PMI is that you can cancel it once you reach 20 percent equity in your home (80 percent loan-to-value ratio), either by paying down your loan balance or by an increase in your home's value, or a combination of the two. So once that happens, you don't have to pay for it anymore.
Even if your home falls in value, your lender must cancel PMI automatically once your loan balance reaches 78 percent of the home's original value through the normal amortization process. That takes about 7 years on a 30-year mortgage with 10 percent down, 9 years if you put down 5 percent. So that's the longest you'll have to deal with it, assuming you keep up with your payments.
Is PMI tax-deductible? Well...maybe. Historically, it hasn't been, but Congress passed legislation in 2007 making it tax-deductible on mortgages taken out beginning that year (pre-2007 mortgages are ineligible). However, that legislation has since expired and while Congress has extended it retroactively several times (most recently through 2014), it has yet to do so for 2015. So while you might eventually be able to take a tax deduction for PMI paid on a mortgage taken out in 2015 or later, it's no sure thing.
The actual premiums your lender pays the insurer for LPMI are comparable to what you'd pay for PMI. However, to cover that, your lender will typically boost your mortgage rate by about one-quarter to one-half of a percentage rate, sometimes more.
Is that a good deal? It depends in part on what you'd be paying in PMI. You need to look at what your total mortgage bill would be with PMI vs. what you'd be paying for LPMI and compare the two.
The major downside of LPMI is that, unlike PMI, you can't get it canceled or reduce your rate once you reach 20 percent equity. You're stuck with that higher rate for the life of the loan. This makes LPMI a poor choice for borrowers who expect to stay in their homes or not refinance for 10 years or more. On the other hand, it can be an attractive option for borrowers who expect to move or refinance before then.
One positive about LPMI is that the cost is tax-deductible for those who itemize, because you're paying for it through a higher mortgage rate - and mortgage interest is tax-deductible. You don't have to worry about Congress extending the deduction for PMI each year. You don't get the deduction if you choose to pay the whole premium as a single fee up front, though.
About FHA mortgage insurance
FHA mortgage insurance is billed in two parts. First, there's the upfront premium billed at the time you take out the mortgage, which is 1.75 percent of the loan amount and can be rolled into the loan itself.
The second is an annual premium, billed monthly, which is 0.85 percent of the loan amount on most 30-year FHA loans. Higher premiums are charged for loans exceeding $625,500; lower premiums are available on 15-year loans and loans with larger down payments. FHA premiums do not vary based on credit score. The circumstances on which you can use FHA loans to buy a second home or investment property are limited, but there's no adjustment to the cost of the mortgage insurance in those cases.
One of the main downsides of FHA mortgage insurance is that you can't ever cancel it if you put less than 10 percent down on a 30-year mortgage. You're stuck with it for the life of the loan. You can get rid of it by refinancing once you reach 80 percent equity, however.
Avoiding mortgage insurance with a piggyback loan
You can sometimes avoid paying for mortgage insurance on a Fannie, Freddie or FHA loan by using something called apiggyback loan. This is a type of second mortgage used to make up the difference between your down payment and 20 percent in order to avoid paying mortgage insurance on the primary loan.
So if you put 10 percent down, you might take out a piggyback loan for another 10 percent down and avoid paying mortgage insurance on the remaining 80 percent that's the primary mortgage. Your rate on the piggyback loan will be higher than on the primary mortgage, but the cost may be lower than you'd pay for mortgage insurance.
Since a piggyback loan is a second mortgage secured by the property, the interest you pay is tax-deductible as well.
This type of arrangement was fairly common prior to the 2008 crash, but is used infrequently these days, and only for borrowers with good credit.
Should you avoid it altogether?
Mortgage insurance is sometimes described as an unnecessary evil - an added expense you can avoid by waiting to buy a home until you can afford a 20 percent down payment. But waiting that long can cost you money as well, by years of paying rent that could be going toward a mortgage and building home equity.
There's another thing to consider in the current environment. Mortgage rates are still at near-historic lows, but it's not clear how long they'll remain that way. If you're looking at a $150,000 starter home, how long would it take you to save $30,000 for a 20 percent down payment? And where will mortgage rates be when you reach that point? Even with mortgage insurance thrown in, an FHA loan at today's rates could look like a bargain in a few years if rates go back to the 6-10 percent range that were considered normal just a few years ago.
Is 20 percent down more financially responsible? To be sure, it does provide you with a larger cushion if you should run into financial trouble and have to sell the home at a loss. It could help protect your credit rating in that event as well. It can even help you qualify for a better mortgage rate. But there are trade-offs, as noted above.
Mortgage insurance can be a useful and cost-effective tool to realize your goal of owning a home without depleting your savings account or taking a decade or more to save up a large down payment. Knowing how it works and the choices available can help you decide just how much of a down payment you actually need, and will help you narrow down your mortgage options as well.