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Do You Really Need Mortgage Insurance?

Mortgage insurance allows people who are tight on cash to buy a home without having to pay the 20% down payment lenders normally expect.

The premiums can open the door to those who may otherwise not be able to buy a home, but they are pricey, both in the short and long term. Many would-be homeowners may be better off saving for that down payment instead. Before you purchase a home that requires you to carry mortgage insurance, weigh the advantages against the disadvantages.

What Does Mortgage Insurance Cover?

Mortgage lenders expect a buyer to provide at least 20% of a home's purchase price as a down payment. Such a sum can be prohibitive, especially when your income is limited, or if you're a first-time homebuyer and don't have existing home equity available. For example, 20% of a $200,000 mortgage would be $40,000, a cost that's likely to overwhelm many homebuyers. It's important for lenders, though, as it protects their interests in the event of default and foreclosure. They'll at least have the funds that you initially put down when you bought the home.

The primary purpose of mortgage insurance is to reduce a lender's risk in lending you money. With that coverage, your insurer will step in to pay the lender if you do not make your payments as agreed. Mortgage insurance can help you buy a home without needing to provide a substantial down payment because it gives the lender confidence the loan will be repaid if you renege.

What Are the Types of Mortgage Insurance?

There are several varieties of mortgage insurance, and the type you obtain depends on the kind of mortgage you get:

  • Private mortgage insurance (PMI): This type of mortgage insurance covers a conventional loan you'd get from a bank or credit union. The cost of PMI can range from 0.5% to 2% of the total loan amount per year and usually is paid monthly. The rate you get is based on factors such as your credit score, the loan type, down payment and length of the loan.
  • Federal Housing Authority (FHA) mortgage insurance: If you have low to moderate income, you may be eligible for an FHA loan that does not require the standard 20% down payment. These loans are issued by lenders that are approved and insured by the FHA. Mortgage insurance is required, and it's broken down into two parts. The upfront mortgage insurance premium is 1.75% percent of the loan amount and you'll make monthly payments toward an annual mortgage insurance premium of 0.45% to 1.05%.
  • U.S. Department of Agriculture (USDA) mortgage insurance: Mortgages issued through the USDA, USDA loans are available to certain suburban and rural homebuyers. Although no down payment is expected, a monthly mortgage insurance premium of 0.5% of the loan amount is required.
  • Funding fees: With a mortgage that's guaranteed through the U.S. Department of Veterans Affairs (a VA loan), you have the option to put down less than 20% without PMI, though funding fees are required. These fees protect the lender in the event of foreclosure much like mortgage insurance. If you're in the regular military, the basic funding fee for a zero down payment mortgage is 2.15%, but it will be less if you put some money down. If you're in the Reserves or National Guard, the basic funding fee is a little higher, starting at 2.40%.

How Is Mortgage Insurance Calculated?

Paying mortgage insurance or funding fees instead of coming up with a large sum of cash for a down payment can be compelling. You may not want to wait many months or years to bid on your dream house. But before you decide, examine the numbers closely. With insurance or similar fees, the monthly payments will be higher than if you made the standard down payment, and the final costs can be extreme. You'll pay PMI premiums until you reach 20% to 22% equity.

Here's how much to buy a home with PMI. Imagine the loan is $200,000, comes with a 30-year term and has an interest rate of 4%. The mortgage insurance is calculated at 1.5%:

  • You would have 88 PMI payments of $235
  • Your mortgage payment plus PMI would be $1,133
  • The total PMI costs would be $20,680
  • After the PMI is removed, your mortgage payments would be $898

On the other hand, if you gave the lender the full 20% down payment ($40,000):

  • There would be no PMI costs
  • Your mortgage-only payment would be $764

Home prices can be far greater than $200,000, so the larger the mortgage and the less you offer as a down payment, the higher those costs will be. To make matters worse, the premiums or fees do not go toward the loan's balance. Run your own numbers in a mortgage calculator prior to entering into such an agreement, and ask yourself if it's truly worth it.

Can You Avoid Mortgage Insurance?

After analyzing the costs, you may find that it's in your best financial interest to offer a lender 20% of the purchase price as a down payment after all. You'd avoid the extra expense associated with mortgage insurance, and the monthly payment will be more reasonable. To make it happen, develop a plan that will add to your income and decrease your expenses so you can save the necessary amount for your goal. Other methods include borrowing from your retirement plan or a relative, or selling unneeded but valuable assets.

If you don't want to delay homebuying and you're comfortable paying the extra costs with mortgage insurance or funding fees, it can also be a wise decision. Maybe you've found a piece of property that's too great of a deal to pass up. There is good news if you use PMI for your conventional loan because the premiums won't last for the life of the mortgage. After you accumulate 20% in equity, you can ask your lender to stop the policy. If you don't reach out to the lender, the insurance will automatically end when your home reaches an equity level of 22%.

As for FHA loans, there is a benefit to coming up with a down payment of at least 10%. The mortgage insurance will stop after 11 years, and at that stage your payments will be lowered. If you don't put that much down, though, the insurance will continue until the loan is paid in full.

Buying a home is an exciting, if not expensive, venture. If you want to start with no or little money down, mortgage insurance or funding fees may be right for you. Then again, you may prefer to wait until you're in a stronger financial position with the full down payment ready to go. The choice is yours.

Whichever direction you choose, obtain your free credit report with Experian long before house hunting so you can clear up any errors you may find and strategically add attractive information to increase your credit score. Doing so will lower the cost of PMI and possibly help you qualify for a lower-interest mortgage.

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