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What is mortgage insurance and how does it work?

Young couple with a young child discussing insurance with a visitor

 

Mortgage Insurance—also referred to as Private Mortgage Insurance or PMI—offers protection for a lender in case a mortgage payment is missed. Borrowers are typically required to pay mortgage insurance if they are making a down payment of less than 20 percent of a home’s purchase price, however it is also required for some federal loans.

Although mortgage insurance increases the overall cost of your loan, it can sometimes allow you to qualify for loans that you may not be able to secure otherwise.

How does mortgage insurance work?

In effect, mortgage insurance lowers a lender’s risk in the event that they offer you a conventional loan. When you are granted a mortgage loan but you subsequently falter on your payments, then mortgage insurance would ensure your lender is still paid. Failure to pay your mortgage payments in full would still bring consequences to you like a lowered credit score and even foreclosure on your home, but your lender would still receive insurance payments for what you owed them.

This type of protection for lenders means that borrowers with insufficient financial standing—like those with poor credit or not enough funds for a 20 percent down payment—can secure loans where they may otherwise be considered too high risk.

There are four main types of mortgage insurance:

  • Borrower-paid mortgage insurance: The most common type, this insurance is included in your monthly mortgage payment.
  • Single-premium mortgage insurance: A lump sum insurance payment.
  • Lender-paid mortgage insurance: This insurance is technically paid by the lender, but results in higher interest rates for the borrower.
  • Split-premium mortgage insurance: This insurance combines a partial lump sum payment upfront and reduced monthly payments.

Do I need mortgage insurance?

You can typically avoid having to pay for mortgage insurance by paying at least 20 percent of a home’s cost as a down payment. Some private lenders offer loans with down payments under 20 percent, which also don’t require mortgage insurance—but these usually come with higher interest rates to balance out the heightened risk for the lender.

If you already pay mortgage insurance, you can sometimes eliminate these payments over time by refinancing your loan. Or, you may request the PMI be dropped by your lender when your mortgage loan balance is less than 80 percent of your home’s original value.

Mortgage Insurance vs. Homeowner’s Insurance

Mortgage insurance is different from homeowner’s insurance in several ways. Homeowner’s insurance protects the borrower in the event of damage or destruction to a home, whereas mortgage insurance protects the lender in the event of delinquent mortgage payments.

Homeowner’s insurance can help rebuild or repair a home’s structure after disaster, and is often required to carry. Mortgage insurance can be avoided, as long as you have good credit history, a source of income, a low debt-to-income ratio and can make a 20% or higher down payment on a loan.

There’s plenty to think about when buying a home, but you don’t have to do it alone. First Tech is here to help, from saving for your goals to navigating the home buying process. Get in touch with an expert from First Tech today to discuss your options.