When you buy a home with a mortgage, the lender is on the hook. A financial institutions lets you borrow money to make a huge purchase, fronting the money so that you don’t have to. You are expected to repay the loan over time, with interest, so that the lender receives it’s money back, plus extra.
But what happens if you default on the loan? The lender is out the money paid up front. In order to reduce some of the risk the lender takes on when loaning you the money, you might be required to purchase mortgage insurance.
Types of Mortgage Insurance
There are two main types of mortgage insurance. The first type is private insurance, which you purchase on a conventional loan. If you put down less than 20 percent for a down payment, the lender will want you to pay for mortgage insurance in order to reduce the risk involved. The second type is insurance paid to the government for home loans backed by government agencies, such as the FHA or USDA.
No matter the situation, the idea behind mortgage insurance is to protect the institution making the loan. If you default on the loan, the lender receives a payment for some or all of the amount that you still owe on your loan. So, even though you pay for the mortgage insurance, you don’t actually receive the payout. Mortgage insurance is one of the prices you pay to qualify for a loan by reducing the risk related to your possible default.
If you are willing to put down 20 percent when you buy, many lenders feel that you have enough “skin in the game” that you are unlikely to default and lose what you have put in initially. If you only put down a small amount, or even no money at all, there is a concern that the fact that you haven’t got any of your own money toward the purchase of your home might mean that you won’t work as hard to avoid a default. Paying for mortgage insurance is a way for lenders to feel more comfortable taking a chance on you.
How Long Do You Have to Pay Mortgage Insurance?
For the most part, you are able to stop paying mortgage insurance when you have 20 percent equity in your home. So, as your loan to value ratio drops, you can have your mortgage insurance cancelled. For conventional loans, you can ask to have your insurance cancelled when you reach a loan to value ratio of 80 percent. When your loan to value ratio reaches 80 percent (you have 20 percent equity in your home), the lender is supposed to cancel the insurance automatically. However, you should still double-check to make sure that your mortgage insurance is cancelled. Certain government loans programs actually require mortgage insurance for the life of the mortgage, as is the case for most FHA loans.
Paying mortgage insurance can be costly in some cases. What you pay depends on where you are, and how big your loan is. It’s not uncommon to be charged anywhere between $25 and $80 per month for every $100,000 you borrow. So, if you borrow $200,000, and your insurance premium is $45 per $100,000, you can expect to pay $90 per month for mortgage insurance. You can see how expensive that gets after a while. Often, the cost of your mortgage insurance is paid along with your regular payment, so it’s added on. When you are estimating what you can afford in terms of buying a home, it makes sense to include potential mortgage insurance costs if you don’t have a 20 percent down payment.
Remember: Mortgage insurance is designed to benefit lenders. If you don’t save up enough for a down payment, you will likely need to bear the cost of mortgage insurance so that lenders feel more comfortable at taking on the risk that you will default.