What Is Mortgage Insurance and How Does It Work?

Author  Lorien Strydom

Editor  Abraham Jimoh

Last updated: May 3, 2024

Mortgage insurance not only provides protection against losses for the mortgage lender but also provides many benefits to mortgage holders.

We look at what mortgage insurance is, how it works, and what the benefits are of the different types of mortgage insurance.

What Is Mortgage Insurance?

Mortgage insurance is an insurance policy that protects the mortgage lender against losses in case the borrower is unable to pay back their loan.

Mortgage insurance provides coverage for the lender in case you are unable to repay your mortgage for any reason, such as defaulting on payments, failing to meet contractual obligations, or passing away.

In 2020, more than 22% of mortgage originations through government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac had private mortgage insurance.

How Is a Mortgage Insurance Premium Calculated?

The calculation of mortgage insurance premiums can vary depending on the type of mortgage and the insurance provider.

However, there are some general factors that are typically used to determine the cost of mortgage insurance:

1. Loan-to-value (LTV) ratio: The LTV ratio is the percentage of the home’s value that the borrower is financing with the mortgage. The higher the LTV ratio, the greater the risk to the lender, and the higher the mortgage insurance premium will be.
   
2. Credit score: Borrowers with a lower credit score may be seen as a higher risk, and therefore may be charged a higher mortgage insurance premium.
   
3. Loan term: The length of the mortgage term can affect the cost of mortgage insurance. Longer mortgage terms may have higher premiums, as there is more time for the borrower to default on the loan.
   
4. Type of mortgage: The type of mortgage can also affect the cost of mortgage insurance. For example, government-backed loans, such as FHA loans, have specific mortgage insurance premiums that are set by the government.

The exact formula for calculating mortgage insurance premiums can be complex and may vary depending on the insurance provider.

However, borrowers can usually find out the cost of their mortgage insurance premium by contacting their lender or insurance provider.

It’s important to note that mortgage insurance premiums are typically added to the borrower’s monthly mortgage payment and can be a significant cost over the life of the loan.

Therefore, borrowers should carefully consider the cost of mortgage insurance when deciding on a mortgage and should explore ways to reduce the cost, like making a larger down payment or choosing a different type of mortgage.

Who Pays for Mortgage Insurance?

Typically, the borrower is responsible for paying for mortgage insurance.

However, the exact terms and requirements for mortgage insurance can vary depending on the type of mortgage and the lender’s policies.

For conventional loans, borrowers may be required to pay for private mortgage insurance (PMI) if they make a down payment of less than 20% of the home’s purchase price.

The cost of PMI is usually added to the borrower’s monthly mortgage payment, and the amount can vary depending on the size of the down payment, the loan amount, and the borrower’s credit score.

For government-backed loans, such as FHA loans, borrowers are required to pay mortgage insurance premiums (MIPs) as part of their monthly mortgage payment.

The amount of MIP depends on the size of the down payment, the loan amount, and the term of the loan.

Homeowners are generally required to have homeowner’s insurance, but this is separate from mortgage insurance and serves a different purpose.

What Are the Different Types of Mortgage Insurance?

1. Mortgage Insurance

Mortgage insurance is a type of insurance policy that protects lenders against losses if a borrower defaults on their mortgage.

There are different types of mortgage insurance policies available, such as single-life and multi-life insurance. Single-life policies cover only one loan while multi-life policies cover multiple loans under one policy.

Additionally, some insurers offer lender-paid premiums which allow the lender to reimburse them for part or all of the cost of coverage.

2. Homeowners Insurance

Homeowners insurance is a type of property insurance that protects the homeowner against losses related to their home and property.

Mortgage lenders require it as part of the loan agreement because it helps protect the lender’s investment in unforeseen circumstances such as natural disasters or accidental damage.

Having homeowners insurance is important for mortgages because it provides peace of mind for both borrowers and lenders.

It ensures that if something unexpected happens, such as damage from a storm or fire, there will be financial coverage for repairs or replacement costs up to the value specified in the policy.

This helps prevent financial hardship from arising from unexpected costs associated with owning a home, which can be especially helpful when taking on debt like a mortgage loan.

3. Private Mortgage Insurance

Private mortgage insurance (PMI) is a type of mortgage insurance that is required for some conventional mortgages when the down payment is less than 20% or equity in the home is less than 20% of its value.

PMI protects the lender if the borrower defaults on their loan and cannot make payments.

It also helps borrowers qualify for larger loans by reducing their down payment requirements and increasing their borrowing power.

PMI can be a concern for homeowners because it increases their monthly mortgage costs, can affect their ability to qualify for other loans or refinance if equity drops below 20%, and can become costly over time if not cancelled before maturity.

Additionally, some borrowers may not realize they need to purchase PMI until after they have already signed their loan documents which could lead to surprises later on down the line when they have to pay additional fees with no advance warning from lenders or brokers.

4. Property Insurance

Property insurance is a type of insurance that covers the owner’s belongings in case of a covered loss, such as fire or storm damage.

Property insurance differs from mortgage insurance in that it provides coverage for personal possessions rather than for the loan taken out to purchase a home.

Mortgage insurance typically provides protection against foreclosure or defaulting on payments, while property insurance provides coverage for damaged or lost items due to natural disasters or other covered events.

Additionally, mortgage insurance typically has higher premiums than property insurance due to its more complex nature and higher risk associated with it.

5. Mortgage Insurance Tax Deductibility

Mortgage insurance tax deductibility is a policy that allows the lender to recover some of their losses in the event that a borrower defaults on their mortgage loan.

This type of insurance can help to reduce the monthly payments for a borrower since some of the costs associated with the loan are covered by the policy.

Additionally, it can help to make it easier for a borrower to qualify for a larger loan and potentially purchase a more expensive home than they otherwise would be able to afford.

6. Flood Insurance

Flood insurance is a type of insurance that protects homeowners against losses caused by flooding. This type of insurance covers the cost of repairing or replacing damaged property and can also be used to pay for temporary housing if necessary.

PMI typically covers up to 20% of the principal balance of a loan, while flood insurance typically covers up to 100%.

Flood insurance is generally mandatory for people living in areas where there is a high risk of flooding; it provides financial assistance when homes are damaged by water damage caused by natural disasters such as hurricanes or floods.

Flood insurance is a type of insurance that protects homeowners against losses caused by flooding.

This type of insurance covers the cost of repairing or replacing damaged property and can also be used to pay for temporary housing if necessary.

PMI typically covers up to 20% of the principal balance of a loan, while flood insurance typically covers up to 100%.

There are several key similarities and differences between flood insurance and mortgage insurance. Both types of insurance protect homeowners against financial losses due to specific events – flooding in the case of flood insurance, and inability to make mortgage payments in the case of mortgage insurance.

However, there are some key distinctions between the two. Flood insurance is typically mandatory for people living in high-risk areas, while mortgage insurance is optional.

Additionally, flood insurance covers damage to the home and property caused by flooding, while mortgage insurance covers the lender in the event that the borrower is unable to make their mortgage payments.

7. Homeowners Protection Act

Homeowners Protection Act (HPA) mortgage insurance is a type of mortgage insurance that protects the lender in the event that the borrower defaults on their loan.

It is typically required for homes with a loan-to-value (LTV) ratio of 80% or higher and can be removed once the borrower reaches an LTV of 80% or lower.

HPA mortgage insurance is different from other types of mortgage insurance because it can be removed once the borrower reaches 80% LTV, whereas other types require ongoing payments until payoff.

Additionally, HPA requires an assessment to confirm home value has not declined since obtaining the loan, while other types may not have this requirement.

8. Insurance Deductible

The insurance deductible is the amount that must be paid out-of-pocket by the borrower before their insurer pays any portion of their claim.

For example, if you have a level-term life policy with a $10,000 deductible, then you must pay $10,000 out of pocket before your insurer will begin paying benefits.

In contrast, an MIP is typically a monthly payment and does not have an upfront deductible requirement; instead, it is added to your loan balance each month until it is paid off in full over several years.

9. Mortgage Banker

Mortgage banker insurance is a type of insurance that protects mortgage bankers against losses caused by defaulting borrowers.

Mortgage banker insurance covers losses incurred by the mortgage lender when a borrower fails to make their payments on time.

It provides protection for the lender in case they are unable to collect on the loan and must foreclose on or sell the property at a loss.

Mortgage banker insurance also covers losses resulting from errors or omissions made by lenders in processing mortgages and other related documents.

Additionally, it may provide coverage for legal costs associated with defending lawsuits filed by borrowers who claim they were misled into taking out loans with high-interest rates or other unfair terms.

How Does Mortgage Insurance Work?

Mortgage insurance is a type of insurance that protects lenders from losses associated with borrower default. It is typically required when the borrower has a down payment of less than 20% of the home’s purchase price.

There are two types of mortgage insurance: private mortgage insurance (PMI) and government-sponsored mortgage insurance (GMI).

PMI is typically required by lenders when the borrower has a down payment of less than 20% of the home’s purchase price.

GMI is typically required by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, when the borrower has a down payment of less than 5% of the home’s purchase price.

Mortgage insurance premiums are paid by borrowers to lenders or GSEs in order to protect them against loss in the event that the borrower defaults on their loan.

MIPs are usually paid monthly, along with the borrower’s regular mortgage payment.

When you apply for a mortgage, your lender will require you to have either PMI or GMI in place before they will approve your loan.

The amount of your premium will depend on factors such as your credit score, loan amount, and down payment amount.

The Benefits of Having Mortgage Insurance

1. Protects the Lender If the Borrower Defaults

Mortgage insurance protects the lender from default because it provides financial protection in case the borrower fails to make their mortgage payments.

This ensures that the lender is able to recover losses incurred from a defaulted loan. Additionally, mortgage insurance often includes coverage for loss of property value due to a foreclosure or short sale, which further protects the lender’s investment in a loan.

2. Lowers the Required Down Payment

Mortgage insurance lowers the required down payment for home buyers by reducing the risk to the lender of making a loan.

As a result, borrowers who would normally need to make a larger down payment in order to qualify for a home loan can have their required down payment reduced or eliminated altogether if they opt for mortgage insurance.

3. Allows for Larger Mortgages

Mortgage insurance helps increase home buying power by providing additional financial security to borrowers.

It protects the lender against loss in the event of a default on a loan and helps reduce the risk of lending money to someone who may not be able to pay it back.

As a result, mortgage insurance enables consumers with low credit scores or limited financial resources to qualify for larger loans than they would otherwise be able to obtain.

This increases their purchasing power and allows them to buy bigger houses with lower down payments than they would otherwise need.

4. Decreases the Amount of Money Paid Upfront

Mortgage insurance typically requires borrowers to pay an additional premium on their loan in order to have coverage.

This added cost can make it more difficult for buyers to come up with the money needed for a down payment on a home, which can in turn lengthen the amount of time it takes to save up enough for a home purchase.

In some cases, borrowers may not be able to remove PMI premiums even if they qualify, which could result in higher monthly payments over the life of the loan.

Mortgage insurance typically requires borrowers to pay an additional cost on their loan in order to have coverage.

This added cost can reduce the amount of money available for a down payment, making it more difficult to purchase a home. In some cases, borrowers may have to wait longer before they can remove PMI if they qualify.

5. Decreases the Likelihood of Having To Put 20% Down

Mortgage insurance protects against default, which means that buyers can purchase homes with smaller down payments.

This is especially beneficial for first-time homebuyers who may not have enough savings for the traditional 20% down payment.

6. Decreases the Amount of Risk for the Lender

Mortgage insurance protects lenders from financial losses in case the borrower defaults on their mortgage payments.

If the borrower defaults, the insurance company will cover a portion of the outstanding balance owed to the lender. This reduces the lender’s risk of financial loss, as they are not solely reliant on the borrower’s ability to repay the loan.

7. Provides Protection Against Property Damage In Case of a Covered Loss

Mortgage insurance protects the lender in the event that the borrower is unable to make their mortgage payments. This type of insurance covers losses such as unpaid interest, penalties, and foreclosure costs.

Mortgage insurance can be purchased separately or included as part of your home loan package. It typically covers up to 20%-50% of your outstanding balance, up to a maximum amount specified by your lender or insurer.

8. Liability Protection for Damage To Other Properties

Liability insurance provides coverage for damage or injuries caused to other people or their property as a result of your actions.

Mortgage insurance, on the other hand, provides protection to the lender in the event that the borrower defaults on their mortgage payments.

This is why it’s recommended to take out liability insurance, in addition to private mortgage insurance when buying a home.

How Do I Cancel My Mortgage Insurance?

The process for canceling mortgage insurance will vary depending on the type of loan you have and the terms of your mortgage insurance policy.

Here are some general guidelines:

Conventional Loans with Private Mortgage Insurance (PMI)

If you have a conventional loan with PMI, you can request to have the insurance canceled when your loan balance reaches 80% of the original purchase price or appraised value (whichever is lower).

If you have a good payment history and a high credit score, your lender may be willing to cancel the PMI sooner.

Your lender is required to automatically cancel the PMI when your loan balance reaches 78% of the original purchase price or appraised value, as long as you are current on your payments.

FHA Loans

If you have an FHA loan, you are required to pay mortgage insurance premiums for the life of the loan. However, if you made a down payment of at least 10%, you may be able to have the MIP canceled after 11 years.

USDA loans: If you have a USDA loan, you are required to pay an upfront mortgage insurance premium and an annual MIP.

The upfront MIP can be financed into the loan and will be canceled when your loan balance reaches 80% of the home’s value. The annual MIP will last for the life of the loan.

Read more: What Is An FHA Loan?

VA Loans

If you have a VA loan, you are not required to have mortgage insurance.

If you are unsure about the terms of your mortgage insurance or when you may be able to cancel it, you should contact your lender or mortgage insurance provider for more information.

In some cases, you may need to pay for a new appraisal or meet other requirements in order to cancel your mortgage insurance.

It’s also important to note that canceling your mortgage insurance may not necessarily lower your monthly mortgage payments, as your lender may adjust your mortgage interest rate or other fees to compensate for the increased risk of lending without insurance.

FAQ