Homebuyers often have mixed feelings about mortgage insurance, and justifiably so. On one hand, mortgage insurance adds to the cost of homeownership. On the other hand, it can make buying a home more accessible.
Over the last few decades as a real estate agent, I've worked with clients anxious to become homeowners. They're wondering: Is mortgage insurance terrible? Do I have to make a 20% down payment to avoid paying mortgage insurance?
Although mortgage insurance may seem like an unwelcome expense, it's actually not a bad thing if you're ready to buy a home. It's important to understand why mortgage insurance exists and how it can benefit you. Here are the top questions my clients and other prospective homebuyers want to know.
How does mortgage insurance work?
Mortgage insurance can be a practical tool if you can't afford a large down payment. Rather than waiting years to save 20% of the purchase price, mortgage insurance lets you buy a home sooner. That could actually save you money in the long run if you're able to lock in a lower home price or interest rate.
Mortgage insurance doesn't protect you. It protects the lender or bank in case you default on your home loan. When a borrower makes less than a 20% down payment, mortgage insurance reduces the lender's risk if you can't cover your loan payments.
There are two primary types of mortgage insurance: private mortgage insurance for conventional loans and mortgage insurance premium for FHA loans.
PMI vs. MIP: What's the difference?
PMI and MIP serve the same fundamental purpose but differ in how they're calculated and what loans they apply to.
PMI is associated with conventional loans and is usually required when the down payment is less than 20%. The cost of PMI is determined by the borrower's credit score and loan-to-value ratio. PMI can eventually be removed once the borrower reaches a certain equity threshold (usually 20%).
MIP is specific to FHA loans and is required regardless of the down payment amount. FHA loans mandate an upfront MIP, followed by annual MIP payments that vary based on the loan's size and term. Unlike PMI on conventional loans, MIP generally lasts for the life of the loan, unless you made a down payment of at least 10%. You can also refinance out of your FHA loan to get rid of MIP.
What if you can't afford mortgage insurance?
To ensure you're financially prepared, factor in mortgage insurance costs and consider them part of your overall homebuying budget. If the additional cost of mortgage insurance feels burdensome, there are ways to prepare.
First, improve your credit score to significantly reduce the cost of PMI, since higher credit scores often lead to lower premiums. Also, if you save for a slightly larger down payment, that can lower the loan-to-value ratio, reducing your PMI costs. These two methods only apply to conventional loans.
It can also be beneficial to explore different loan options, such as VA loans for veterans, which don't require mortgage insurance.
Is mortgage insurance always a different fee?
Mortgage insurance is often paid separately from your monthly mortgage payments, but it's not always a distinct line item. Depending on the type of loan and the lender's policies, mortgage insurance costs may be covered in different ways. Make sure to talk to your lender and read the fine print to know exactly how you'll be paying for mortgage insurance.
For conventional loans, PMI can be paid monthly, as an upfront fee or a combination of both. Some lenders offer the option of waiving the monthly PMI payments in exchange for paying a higher interest rate, effectively incorporating the cost into the mortgage rate.
FHA loans typically include an upfront MIP, which can be paid at closing or rolled into the loan amount, and an annual MIP, which is paid monthly.
Is Dave Ramsey right about 20% down?
Financial expert Dave Ramsey advises his followers to put down 20% to avoid having to pay mortgage insurance. While this advice is sound in theory, it may only be practical for some buyers who can afford a hefty down payment in today's competitive housing market.
With home prices rising, saving 20% of a home's purchase price can take a long time, and potential buyers might miss out on market appreciation.
Should you avoid paying mortgage insurance?
Mortgage insurance is a cost of leveraging your investment, helping you gain access to the real estate market and start building equity while fixing your housing costs. Even if you could avoid mortgage insurance by waiting to cover a larger down payment, the rising cost of homes or the volatility of mortgage interest rates could offset your savings.
In the end, the benefits of mortgage insurance could definitely outweigh the costs. It all depends if it's the right time in your life to buy.
