If you choose to buy a home with little or no money down, there’s an additional expense you’ll have to factor into your housing budget — mortgage insurance.
There are two types of mortgage insurance and while their names sound similar, the one you have to pay depends on the kind of loan you have.
Understanding private mortgage insurance (PMI) and mortgage insurance premium (MIP)
Whenever you put less than 20% down to buy a home, you’re going to have to pay insurance to protect the lender who put up the money for you to buy your house.
Lenders ideally want you to have “skin in the game” so they know that you’re not just going to walk away from your home and stop paying your mortgage, as many people did last decade when they ran into financial trouble and lost their jobs during the recession.
So in the absence of that skin in the game, you must pay mortgage insurance to protect the lender in case you go into default on your loan.
The two types of mortgage insurance are private mortgage insurance (PMI) and mortgage insurance premium (MIP). Let’s take a look at each…
Private mortgage insurance
For conventional loans, you must pay PMI anytime you put down less than 20% on your home purchase. The cost of PMI will vary depending on exactly how much money you put down, but a good rule of thumb is that it can be up to 1% of the loan.
Your PMI premium is typically rolled into your mortgage payment, which means it’s a monthly expense for most people. Many homeowners don’t consider the cost of PMI, but it can be in the thousands of dollars over the life of a loan.
Fortunately, if you start a private loan with PMI, there are a couple of ways to get out of it:
- Lenders are required to remove PMI when your loan balance reaches 78% of the original value of your home.
- You can request that your PMI be cancelled when you have 20% equity in your home. In order to do this, you must hire a lender-approved appraiser to develop a fair market value for your lender. You’ll also want to be sure you haven’t missed any payments over the last 12 months because that in itself could foul up your PMI cancellation request.
- PMI can also be shed when you reach the middle of your amortization period. For example, if you’re 15 years into a 30-year loan, you’re at the midpoint and can request that PMI be dropped. In addition, some lenders will reduce the amount of PMI you pay after 120 months (10 years), provided you’ve been making timely payments. Check with yours to see if they’ll do this.
If you’re weighing getting into a mortgage with PMI, we should note that a handful of lenders will lend you money to buy a home with very little down payment and no mortgage insurance requirement.
Bank of America has its Affordable Loan Solution mortgage that only requires 3% down and no PMI. Meanwhile, NASA Federal Credit Union has an offer that’s even more extreme. Their $0 DOWN fixed-rate mortgage requires no down payment and no PMI!
Now, as to the question of whether or not you should ever think about getting into a home with less than 20% down, you can read money expert Clark Howard’s take here.
Mortgage insurance premium
MIP is a cousin of sorts to PMI, but it only applies to FHA-backed loans that are taken out with down payments of less than 20%.
The FHA loan program has long offered you the ability to bring a much smaller amount of money than 20% to the closing table. In fact, most FHA loans only require a 3.5% down payment of the purchase price. But here’s the kicker: Depending on how much less than 20% you put down, you could be locked into MIP for the life of the loan.
MIP is collected in one of two ways: Either monthly while rolled into your mortgage payments (currently set at 1.75% of the base loan amount) or as a one-time upfront payment included in closing costs.
As to exactly how long you’ll have to pay MIP, the FHA website explains it the following way:
LTV (loan-to-value ratio) greater than 90%
Annual MIP will be collected until the end of the loan term, or 30 years, whichever occurs first.
LTV less than or equal to 90%
Annual MIP will be collected until the end of the loan term, or 11 years, whichever occurs first.
Either way, that’s a pretty long time to be paying MIP!
That’s why many people with FHA loans will refinance into a private mortgage as soon as they can. Your ability to refinance out of an FHA loan is contingent on having enough equity in your home; whether the prevailing mortgage interest rates of the time are enticing enough for you to refinance; and your overall credit health.