The concept behind mortgage insurance is not quite the same as with other insurance plans. You pay a monthly premium to the insurer who protects the mortgage lender in the event you default. There are two types of mortgage insurance: government and private.
What is private mortgage insurance? (PMI)
PMI is insurance for the mortgage lender's benefit, not yours. It's a concession often required when your down payment on the purchase of a home is less than 20%. Because the lender is assuming additional risk by accepting a lower amount of upfront money towards the purchase, they will often call for the borrower to purchase private mortgage insurance.
Private mortgage insurance will pay the lender a portion of the balance of the principal due if you stop making payments on your loan. PMI will typically pay the difference between a conventional 20% down payment and what a borrower actually paid upfront.
For example, if you put down 5% to purchase a home, private mortgage insurance might cover the additional 15%. A loan default triggers the policy payout as well as foreclosure proceedings; so that the lender can repossess the home and sell it in an attempt to regain the balance of what is owed.
The cost of private mortgage insurance is based on the size and type of mortgage loan you are applying for, your down payment and credit score. The average annual cost can range from 0.55% to 2.25%, according to insurance firm Genworth and the Urban Institute, an economic think tank.
Once your mortgage principal balance is less than 80% of the original appraised value or the current market value of your home, whichever is less, you can generally cancel the private mortgage insurance. Often there are additional restrictions, such as a history of timely payments and the absence of a second mortgage.
Mortgage lenders are required to tell you at closing how long it will take for you to reach that loan-to-value mark, and update you annually of any cancellation options. Generally, mortgage lenders are required to cancel PMI once the mortgage balance dips down to 78% of original value.
Private mortgage insurance can also be terminated if you reach the midpoint of your payoff. For example, if you took out a 30-year loan and you've completed 15 years of payments, PMI may be terminated.
Mortgage insurance for loans guaranteed by the Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) operates a little differently from conventional mortgages.
VA loans to active, disabled or retired military servicemembers and their eligible surviving spouses never require mortgage insurance, but most borrowers will pay a "funding fee" ranging between 1.25% and 3.3% for purchase loans. This fee depends on a wide variety of factors, including whether you've applied for a VA loan before and how much money you're putting down, if any.
VA loans are also available to certain reservists and National Guard members. Others may also qualify. The VA Eligibility Center has details at 888-768-2132.
Mortgages backed by the FHA require a 1.75% upfront mortgage insurance payment as well as monthly mortgage insurance premiums ranging from .45% to 1.05%, depending on the loan term and amount. (Premium rates as of January 2017.)
Mortgage insurance allows a lot of people to become homeowners who otherwise might not be able to. And it's natural to want to put down as little money as possible, but you'll want to consider the real costs now and down the road.The way the system works is: The larger the down payment, the better your financing deal. You'll get a lower mortgage interest rate, pay fewer fees and gain equity in your home more rapidly. But ultimately it's a matter of balancing your short-term financial capabilities with the realities of your local real estate market and your future savings and earnings potential to determine the best long-term financial result for you.
Hal Bundrick is a staff writer at NerdWallet, a personal finance website.