Mortgage Insurance, What is it?
We breakdown my biggest pet peeve
Mortgage Insurance seems like the biggest scam on planet earth.
Every time i go into finer details of what MI is with people, by the end of the conversation, the client and I are both left annoyed and scratching our heads as to the why and how it came to be this way.
It might be my BIGGEST pet peeve in this industry.
Nonetheless, it is worth it still to understand it when you buy a home. So, here we go:
If you are buying a home and your down payment is less than 20% of the purchase price, you will have to pay some form of mortgage insurance; either a onetime fee at closing, or included in your monthly mortgage payment, or BOTH.
The crazy part here is that, that mortgage insurance you are paying for... DAH DAH DAAAAAAAHHH...isn't even for you!
You are paying mortgage insurance for YOUR lender. In the event that YOU stop making your payments and default on the loan, the mortgage insurance guarantees the lender will be recouped the money they have invested in the home. Does that sound a little backwards to you? and dare I say, swarmy. (hence my choice of a swarm of birds as the cover photo)
The lender is requiring that you pay their insurance and charging you money each month, just in case you can't make your monthly payments. I think the natural response here would be,.. "well, don't charge me extra each month, and maybe I could afford to make my payment"
As CRAZY as it sounds, the why is somewhat rational (somewhat) and designed to protect lenders in case borrowers default on their loans. It was born out of a desire for lender's to offer you higher loan to values because people can't afford to always put 20% down payments. For example, here in the Richmond VA market, its not uncommon for a starter home to be around $250,00 - $300,000. 20% of $300,000 is $60,000. I don't $60,000 for a down payment. In order for lenders to offer 3% down payment options, they tack on this "Mortgage Insurance" to offset the risk.
So different loan options come with distinct mortgage insurance requirements. Here, I'll break down the differences between the 4 major loan types; Conventional, FHA, USDA, and VA loans and which one is the worse (spoiler alert, its FHA). Sorry if the following info is very, very dry. Unfortunately, ChatGPT can't even make MI sound exciting.
Conventional Loans:
With a conventional loan (conventional meaning non government backed loan), home buyers typically pay mortgage insurance when their down payment is less than 20% of the home's purchase price.
On Conventional Loans this insurance is known as Private Mortgage Insurance (PMI). The cost of PMI varies based on factors such as the borrower's credit score, the loan-to-value ratio, and the size of the down payment. It can be anywhere from $15 more a month to $200 more. The smaller the down payment the more expensive the PMI.
PMI is added to the monthly mortgage payments, making homeownership more accessible for those who can't afford a substantial 20% down payment. The good news for you in all of this is that with a conventional loan, as you pay down the mortgage and the home's value increases, you will reach a point where it is no longer required to be apart of your monthly payment. This happens at 80% (the 20% ownership mark) . At this stage, the homeowner can request the removal of PMI by calling their lender and reducing their monthly mortgage burden.
FHA Loans:
Mortgage insurance with FHA loans is not as good as conventional loans for a couple reasons. Because the Federal Housing Administration (FHA) backs these loans instead of a private company, they get to set the rules. In order to make the loans more available to people who might not qualify for conventional loans (due to lower credit scores or smaller down payments options), they have a different form of mortgage insurance and not "PMI".
FHA loans require home buyers pay what is called Mortgage Insurance Premiums (MIP). (Of course the government had to change the order of the acronym). MIP is divided into an upfront fee due at closing (1.75% of your TOTAL loan amount) typically added in, or rolled, into the loan amount, PLUS ongoing monthly payments.
The upfront MIP fee is a percentage of the loan amount and serves as a form of insurance for the lender. The ongoing monthly MIP payments contribute to the FHA's insurance fund, which supports the program's sustainability. The biggest issue with MIP on FHA loans is that it doesn't automatically terminate when the borrower reaches a certain ownership ratio like Conventional. You stop paying PMI on conventional loans when you reach 20% ownership, however, the monthly MIP remains in your monthly payment throughout the life of the loan,
Let me write that again for the people in the back, YOU WILL PAY MORTGAGE INSURANCE FOR THE LENDER FOR 30 YEARS if you don't ever refinance your FHA loan to a conventional or change your loan terms.
USDA Loans:
Another loan backed by the government, USDA is for those seeking homes in rural or suburban areas, the U.S. Department of Agriculture (USDA) provides loans with favorable terms. You do not need a down payment at all on USDA loans and the only qualifier is that it cannot be within a city's limits.
USDA loans require borrowers to pay a 1% Guarantee Fee upfront, (similar to purpose to the 1.75% FHA upfront fee, but almost half the cost. Again, this upfront fee can just be added to the end of the loan and not necessarily "due" at closing, even though it says upfront. It just means it's only charged once.
In addition to the Guarantee Fee, USDA loans also have monthly fees. These fees are calculated based on the remaining loan balance and are divided into 12 monthly payments. Once the borrower achieves a certain level of equity in their home, these fees may be eliminated.
VA Loans:
VA loans, exclusively available to eligible veterans, active-duty service members, and select members of the National Guard and Reserves, stand out for not requiring mortgage insurance at all!
The Department of Veterans Affairs guarantees a portion of these loans, allowing lenders to offer favorable interest rates and terms without the need for mortgage insurance. This feature makes VA loans an attractive option for those who qualify. They have an upfront, one time fee, called a VA funding fee, which is similar to the FHA and the USDA Guarantee Fee. However, it is most costly of the upfront, onetime fees, being 2.15% (compared to 1% or 1.75%) for your first home purchase with a VA loan and 3.3% for any subsequent use.
Some silver-lining though, is that it may be possible to waive that Funding Fee completely, if you have service-related disability claim into the VA.
Hopefully, this gives you a little more insight into the why and the how of MI. And who knows, maybe the more people that understand and don't default on their mortgage, might cause the percentages of MI to decrease. Maybe wishful thinking.