What is mortgage insurance?
Mortgage insurance is offered by either the government or private insurance companies to enable lenders to offer smaller down payments on loans. Before mortgage insurance existed, many had to pay a minimum of 20% down to purchase a home which made homeownership unaffordable for many Americans. Mortgage insurance covers lenders for losses up to a certain amount if a borrower defaults on their mortgage.
There are two types of mortgage insurance available:
- FHA mortgage insurance. FHA is a government program which requires a down payment of as little as 3.5% of the sales price and mortgage insurance is required on FHA mortgages, regardless of the amount of down payment.
- Conventional mortgage insurance. Conventional mortgages are home loans that are not insured or guaranteed by the government, as in the case of the FHA mortgage example. Many conventional loans are sold to Fannie Mae or Freddie Mac and thus follow these entities “conforming” guidelines.
Conventional or private mortgage insurance enables lenders to offer conventional loans with a minimum down payment of 3.0% to 5.0%. Many 3.0% down conventional mortgages are restricted to low-to-moderate income borrowers.
Example of down payment costs:
—$400,000 home purchase with a 20% down payment requires $80,000.
—$400,000 home purchase with a 5.0% down payment requires $20,000.
—$400,000 home purchase with a 3.0% down payment requires $12,000.
One can see a great benefit from being able to use mortgage insurance from a conservation of cash perspective.
What is the cost of mortgage insurance?
The cost of mortgage insurance will vary greatly, depending upon several factors:
•The mortgage insurance alternative selected.
•The amount of the down payment.
•The type of the mortgage such as a 30-year or 15-year loan – or an adjustable rate mortgage.
•Whether the mortgage insurance is paid for by the borrower or financed through a higher interest rate.
•The qualifications of the borrower, especially the credit score.
•Whether the mortgage is a FHA or conventional loan.
In addition, depending upon the alternative selected, the cost of mortgage insurance can be an upfront fee, an additional monthly payment, or financed into the loan amount or interest rate. Or the cost may be represented by some combination of these alternatives.
What are the alternatives and the advantages of each?
There are a wide variety of mortgage insurance alternatives. In this case, we compare two major alternatives. Conventional mortgage insurance paid monthly and conventional mortgage insurance in which the cost of insurance is paid through a higher interest rate.
These examples are for illustration only:
Monthly example: $300,000, mortgage insurance rate of .40%. The monthly payment would be $100.00 per month.
Higher interest rate example: $300,000 mortgage and 0.375% added to the interest rate: approximately $65.00 per month in additional payment monthly.
At first blush, opting for a higher interest rate in this case would be the best option. However, there are other factors involved:
•In both cases the interest on the mortgage or the separate mortgage insurance payment is likely to be tax deductible. However, if your income is higher than $110,000 annually, the monthly mortgage insurance payment may not be deducted from your taxes. In addition, the deduction of separate mortgage insurance payments is extended on a year-to-year basis by Congress and thus has not been made permanent.
•Monthly mortgage insurance can be cancelled after a certain period of time with some restrictions such as keeping current on your payments. The payment can be cancelled:
•When the loan reaches 80% of original sales price based upon regular amortization (the lender must do so automatically when it reaches 78%); or
•When the loan reaches 75% of the present value of the property and two years of payments have been made; or
•When the loan reaches 80% of the present value of the property and five years of payments have been made.
In addition, if the loan is an FHA loan with a minimum down payment, the mortgage insurance can never be cancelled.
This means that if the home was purchased below market value, significant improvements are to be made to the home, or if the owner is going to pre-pay the mortgage, one may have to pay the monthly mortgage insurance payment for as little as two years before cancelling it. When you roll the mortgage insurance cost into the interest rate, you would have to pay until the loan is paid off in the long-term, or the home is sold, or the loan is refinanced.
Can I avoid mortgage insurance and still make a low down payment?
There are options to eliminate mortgage insurance altogether by getting a second mortgage on the property. Here is an example:
—$400,000 sales price, 10% down payment, $360,000 mortgage with mortgage insurance.
—$400,000 sales price, 10% down payment, $320,000 first mortgage with a $40,000 second mortgage and no mortgage insurance. Note that most loan programs require a higher rate for a first mortgage when adding a second mortgage.
Like the choice of mortgage insurance options, there are advantages and disadvantages with both alternatives, besides the difference in payments. For example, while the mortgage payment is more likely to be tax-deductible under the first and second mortgage scenario, you must pay on a second mortgage until it is paid off or is refinanced, while the mortgage insurance may be cancellable in the future.
In addition, the second mortgage is likely to be at a higher interest rate as compared to the first mortgage and could either be amortized over 15-years which requires a higher payment, or an adjustable rate mortgage, whose rate may change in the future. Thus, the home purchaser must consider additional benefits and costs besides the difference in payments.
The decision of whether to pay mortgage insurance or not and what alternatives to choose is complex and will change based upon the situation, including the qualifications of the buyer and the nature of the transaction. That is why it is so important to obtain the advice of an expert mortgage advisor before you purchase a home.
