Is mortgage insurance a bad thing?
Private mortgage insurance (PMI) is usually required if you put less than 20% down on a house.
Many homebuyers try to avoid PMI at all costs. Why? Because unlike homeowners insurance, mortgage insurance protects the lender rather than the borrower.
But there’s another way to look at it.
Mortgage insurance can put you in a house a lot sooner. You might pay more than $100 per month for PMI. But you could start gaining tens of thousands per year in home equity.
For many people, PMI is worth it. It’s a ticket out of renting and into equity wealth.
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What is mortgage insurance?
Private mortgage insurance (PMI) is a type of insurance policy that protects mortgage lenders in case borrowers default on their loans. You’re usually required to pay for PMI if you make a down payment smaller than 20 percent. With some mortgages, PMI is a temporary requirement. But with others, it will last the life of the loan.
Why PMI is required
If a borrower defaults on their home loan, it’s assumed the lender will be set back about 20% of the home’s purchase price.
If you put down 20%, that makes up for the lender’s potential loss if your loan defaults and goes into foreclosure. Put down less than 20%, and the lender is likely to lose money if the loan goes bad.
That’s why mortgage lenders charge insurance on conventional loans with less than 20% down.
The cost of PMI covers that extra loss margin for the lender. If you ever default on your loan, the lender will receive a lump sum from the mortgage insurer to cover its losses.
Is PMI bad for homeowners?
Paying monthly PMI might sound like a tough deal. But the upside is, mortgage insurance gives you a fast track to homeownership.
Without mortgage insurance, many people would have to wait years to save up for a bigger down payment before buying a house. Those are years they could have spent investing in their home and building equity, rather than paying rent to a landlord each month.
Plus, most borrowers can eventually cancel their PMI. So you’re not stuck with the added fee forever. It’s a temporary cost that can have very long–term rewards.
How much is private mortgage insurance?
Private mortgage insurance costs vary by loan program (see the table below). But in general, the cost of PMI is about 0.5–1.5% of the loan amount per year. This is broken into monthly installments and added to your monthly mortgage payment.
So for a $250,000 loan, mortgage insurance would cost around $1,250–$3,750 annually or $100–315 per month.
Some mortgage types also charge an upfront mortgage insurance fee, which can often be rolled into the loan balance so you do not have to pay it at closing.
Mortgage insurance rates
Note that for most loan types, there are two mortgage insurance rates: An annual rate and an initial rate or “fee.”
The initial mortgage insurance fee is usually higher, but it’s only paid once when the loan closes. And both types of mortgage insurance vary by loan program. As a rule of thumb, these costs are generally affected the most by a borrower’s credit score and loan–to–value ratio.
|Conventional Loans||FHA Loans||USDA Loans||VA Loans|
|Initial Mortgage Insurance||n/a||Upfront Mortgage Insurance Premium||Upfront Guarantee Fee||Funding Fee|
|Annual Mortgage Insurance||PMI Annual Premium||Mortgage Insurance Premium||Annual Fee||n/a|
*Mortgage insurance rates are shown as a percentage of the loan amount
**VA funding fee is 2.3% for a first-time home purchase zero down and up to 3.6% for subsequent uses
Cost of mortgage insurance by loan type
Each loan type has a different mortgage insurance rate. So even for the exact same loan size, mortgage insurance costs could be very different depending on whether you got a conventional mortgage, FHA, VA, or USDA mortgage.
For example, say you buy a $300,000 home with 3.5% down. Here’s how mortgage insurance costs would compare for the four major loan types:
|Conventional Loan||FHA Loan||USDA Loan||VA Loan|
|Initial Mortgage Insurance Cost||$0||$5,000||$2,900||$6,700|
|Annual Mortgage Insurance Cost*||$3,500||$2,500||$1,000||$0|
The above example assumes a $300,000 home purchase price with 3.5% down, and a 30-year fixed-rate of 3.75%. Your own interest rate and mortgage insurance costs will vary
*Annual mortgage insurance cost is calculated based on year 1 loan balance. Annual costs will go down each year as the loan balance is reduced
How is mortgage insurance calculated?
Mortgage insurance is always calculated as a percentage of the mortgage loan amount. It is not based on the home’s appraised value or purchase price.
For example: If your loan is $200,000, and your annual mortgage insurance is 1.0%, you’d pay $2,000 for mortgage insurance that year. That breaks down to a payment of $166 per month.
Since annual mortgage insurance is re–calculated each year, your PMI cost will go down every year as you pay off the loan.
Calculating mortgage insurance by loan type
Conventional PMI mortgage insurance is calculated based on your down payment amount and credit score. Rates can vary a lot by borrower but are often around 0.5% to 1.5% of the loan amount per year (paid in monthly installments).
For FHA, VA, and USDA loans, the mortgage insurance rate is pre–set. It’s the same for just about every customer.
- FHA: 1.75% of loan amount upfront and 0.85% annually
- USDA: 1% of the loan amount upfront and 0.35% annually
- VA: Between 0.5% and 3.6% upfront depending on borrower and loan purpose
Typically, the ongoing annual premiums for mortgage insurance are spread across 12 monthly installments. You simply pay it each month as part of your regular mortgage payment.
Calculating mortgage insurance by credit score
The following chart compares cost differences between the three major types of mortgage insurance, based on a $250,000 loan amount, and varying credit levels.
|660 FICO Score||700 FICO Score||740 FICO Score|
|Conventional 5% Down||$295||$180||$120|
|Conventional 10% Down||$210||$125||$85|
|FHA 3.5% Down||$177||$177||$177|
|USDA 0% Down||$66||$66||$66|
Use a mortgage calculator to gain a better understanding of the impact PMI payments will have on your home buying budget. Experiment with down payment percentages, loan terms, home purchase prices, and other variables to get an idea of how much PMI may cost.
Additionally, mortgage calculators help you understand your total estimated monthly mortgage payment, including homeowners insurance, property taxes, and principal and interest.
Cost versus benefit of private mortgage insurance
Many home buyers only think about the upfront cost of PMI. But what they don’t realize is that PMI can have a great return on investment. That’s because PMI can help you buy a home much sooner. And typically, the amount you pay for PMI is far, far less than the wealth you’ll gain via home equity.
PMI and home price appreciation
Consider that today’s homeowners are building wealth more rapidly than previous generations.
According to the Federal Housing Finance Agency (FHFA), U.S. home prices “rose 17.5% from the fourth quarter of 2020 to the fourth quarter of 2021.” That translates into an average gain of $56,700 in home equity per borrower.
What’s more, Fannie Mae and Freddie Mac predict this growth trend will continue with an estimated rise of 7.4% through 2022 and 2.9% in 2023.
What’s surprising, then, is “advice” saying you should buy a home only when you have a 20% down payment.
Putting 20% down is less risky than making a small down payment, but it’s also costly.
Even strong opponents of mortgage insurance find it hard to argue against this fact: PMI payments, on average, yield a huge return on investment.
PMI return on investment
Home buyers often try to avoid PMI because they feel it’s a waste of money.
In fact, some forgo buying a home altogether because they don’t want to pay PMI premiums.
That could be a mistake. Data from the housing market indicates that PMI yields a surprising return on investment.
Imagine you buy a house worth $233,000 with 5% down.
The PMI cost is $135 per month according to mortgage insurance provider MGIC. But it’s not permanent. It drops off after five years due to increasing home value and decreasing loan principal.
Remember, you can cancel mortgage insurance on a conventional loan when your mortgage balance falls to 80% of your home’s purchase price.
The homeowner’s snapshot at the end of year 5 looks like this:
- Current value: $276,000
- Principal remaining: $200,000
In five years, the home has appreciated $43,000, and the final PMI cost is $8,100. That’s a 5–year return on investment of 530%.
It’s nearly impossible to make that kind of return in the stock market, retirement account, or another financial instrument.
PMI, then, can be viewed as an investment – a very sound one – and not a waste of money.
Homeownership is the primary means of wealth building in the U.S. Each monthly mortgage payment can be considered an investment in the future.
Owning a home is no path to quick riches. Rather, it’s an investment that pays off gradually over time, even considering cyclical downturns.
And a house is a forced savings account. Housing expenses are required whether you rent or own. But when you own, you deposit a small chunk toward your future wealth each month. When you rent, you don’t see any return on that investment.
So what does PMI have to do with this?
Well, PMI starts the wealth–building process sooner. You can get into a home without waiting years and years to save for 20% down. And you could be on the winning side of rising home values.
When can I cancel PMI?
If you have a conventional (non–government) mortgage loan, PMI cancellation should happen automatically when your loan–to–value ratio (LTV) falls to 78% of your original balance.
As an example, when the principal on a $300,000 loan drops to $234,000, your LTV ratio is 78% and your mortgage servicer will automatically cancel PMI.
You also have the option of canceling PMI once your LTV ratio drops to 80%.
Keep in mind that these rules apply only to conventional loans (those backed by Fannie Mae and Freddie Mac). Mortgage insurance works differently for government–backed loans such as USDA and FHA mortgages.
FHA mortgage insurance premium (MIP)
FHA loans, backed by the Federal Housing Administration, require their own type of mortgage insurance. This is known as mortgage insurance premium or MIP.
MIP charges two separate fees: an upfront payment and an annual one:
- Upfront mortgage Insurance premium (UFMIP) costs 1.75% of the loan amount. It can be paid at closing but most home buyers roll it into the loan balance
- Annual mortgage insurance premium (MIP) costs 0.85% of the loan amount per year, split up into 12 installments and paid monthly with the mortgage payment. This is due the life of the loan unless you put at least 10% down. In that case, the MIP payments will cancel after 11 years
Of course, a homeowner could refinance out of an FHA mortgage to get rid of their MIP payments. If the home’s loan–to–value ratio has fallen below 80%, refinancing into a conventional loan could help eliminate MIP later on.
USDA and VA loans
USDA loans also charge both an upfront and ongoing mortgage insurance fee. However, USDA mortgage insurance rates are slightly lower, with a 1% upfront fee and 0.35% annual charge.
VA Loans, backed by the federal Department of Veterans Affairs, do not require ongoing mortgage insurance payments. The VA charges a funding fee upfront to help insure lenders, but there’s no added monthly charge for the borrower.
How do I know if PMI is right for me?
Private mortgage insurance isn’t for everyone, but, depending on your financial situation, consider checking the potential returns on the costs of PMI before automatically refusing to pay it.
Check your home loan options to see what you can afford and how much mortgage insurance would actually cost you.
The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.