Mortgage insurance and homeowners insurance

by Elizabeth Rosen, Contributor

When you buy a house, you will be responsible for many expenses beyond the home’s price tag. It is important to understand the various costs associated with your purchase, including mortgage insurance and homeowners insurance, both which are typically required.

MORTGAGE INSURANCE

Mortgage insurance helps protect the mortgage lender in case you (the borrower) fail to make the mortgage payments and it is designed to pay off the mortgage in the event of a loan default. Most lenders will require you to purchase mortgage insurance if your down payment is less than 20% of the home’s purchase price. Mortgage insurance is paid by the borrower, since they present the risk for loan default. If you happen to default on your mortgage loan, the insurance will ensure that the lender is still reimbursed.

Private Mortgage Insurance (PMI)

The term ‘private mortgage insurance’ means you are dealing with a private insurance company, as opposed to government-backed mortgage insurance (see below). Mortgage companies choose the insurance providers for the borrowers, who are responsible for the PMI payments.

Government Mortgage Insurance (FHA & VA)

If you obtain a mortgage loan through an FHA (Federal Housing Administration) or VA (U.S. Department of Veterans Affairs) program, you will be subject to government mortgage insurance. While an FHA loan, for example, has a much lower down payment requirement (as low as 3.5% for certain borrowers) and lower credit score requirement than most private lenders will offer, FHA mortgage insurance requires both an up-front premium as well as a monthly premium.

The Cost of Mortgage Insurance

The cost of mortgage insurance is based on a number of factors, including the size of the home loan, the size of your down payment, your credit score and the loan-to-value ratio.

When you are going through the home buying process, the mortgage lender will arrange an appraisal of the home to verify its market value. Lenders will generally only approve mortgage loans which are less than 90% of the home’s value. 

Mortgage insurance typically costs 0.5-1% of the total home loan amount. Insurance premiums are usually held in an escrow account and then added on to your monthly mortgage payments.

Avoid Mortgage Insurance

In most cases, mortgage insurance is only required if the borrower makes a down payment that’s less than 20%. This is because a larger down payment means you have more equity in the home, which the lender can use as a way to recoup their losses if you default and the home winds up in foreclosure. Therefore, making a substantial down payment (20% or more) may be able to help you avoid paying for mortgage insurance altogether.

Another way to avoid mortgage insurance is to take out a second loan that brings the first mortgage down to 80% of the home’s purchase price. This is also known as a “piggyback loan.”

While homebuyers are often trying to find ways to avoid mortgage insurance, you should realize that it’s not necessarily a negative factor. In some instances, mortgage insurance could actually help you get approved for a home loan because it helps the lender to reduce their risk.

Cancel Mortgage Insurance

As you pay down your mortgage loan, your LTV ratio will decrease. At a certain point, you should be allowed to request cancellation of your mortgage insurance. Make sure you talk to your lender about the required LTV ratio, and keep an eye on yours so you don’t end up paying for mortgage insurance longer than you need to.

HOMEOWNERS INSURANCE

In order to get a mortgage loan and purchase a home, you must also insure the property. As with any product, you will get the best deal on homeowners insurance if you do some research and shop around for quotes. Different insurance companies provide different levels of service, and some may charge different rates for the same coverage. Keep in mind that certain regions have special requirements for hazard insurance, such as earthquakes and floods.

Once you decide on the type of home insurance coverage you need and the policy limits, you must also determine how much it would cost to rebuild your home. It’s generally recommended that your insurance coverage be equal to the full replacement cost of your home. Keep in mind that the replacement cost and the market value of your home are different. (The market value of your home includes the price of your land and is subject to fluctuations in the real estate market.) A contractor or insurance agent may be able to help estimate the replacement cost of your home.

Homeowners insurance serves two main purposes. First, it satisfies your mortgage lender, who will be listed on your insurance policy. Since the lender is providing you with a large loan and will be responsible for the property if you default or foreclose, they want to be certain that the property is insured to reduce their exposure to risk. Second, homeowners insurance helps protect your assets including your home and your personal property. Your insurance policy can also cover your liability (i.e. your personal legal responsibility) if another person (or their property) is injured while on your property.

It’s important to remember that your homeowners insurance policy is a legal contract. After receiving your policy in the mail, make sure to store it in a safe place.

Types of Coverage for Homeowners Insurance

  • Most homeowners insurance policies are presented as packages of coverage. Your insurance will only cover the types of peril stated in your policy. Here are some of the main types of home insurance coverage:
  • Dwelling — Covers damage to your house and the structures attached to your house. Also includes fixtures, plumbing, electrical wiring, heating, and permanently installed air conditioning systems.
  • Other structures — Covers damage to fences, tool sheds, freestanding garages, guest cottages, pool houses, and other structures not attached to your house.
  • Personal property — Reimburses the value of your possessions if damaged or lost, such as furniture, electronics, appliances, and clothing. Also includes items belonging to you which are not on your property, like the contents of an off-site storage locker.
  • Loss of use — Covers additional living expenses while your home is being repaired.
  • Personal liability — Covers your financial responsibility if you are sued and found liable for damages or injures to another person.
  • Medical payments — Covers medical bills for people who are injured on your property or by your pet.

Types of Homeowners Insurance Policies

There are seven standardized homeowners insurance policies, which are issued by the Insurance Services Office (ISO) for resale to insurance companies.
• HO1 — Basic Form Homeowner Policy
• HO2 — Broad Form Homeowner Policy
• HO3 — Special Form Homeowner Policy
• HO4 — Renter’s Insurance
• HO5 — Premier Homeowner Policy
• HO6 — Condominium Policy
• HO7 — Older Houses

Homeowners insurance is designed to reimburse you for property damage caused by a covered peril (such as theft, fire, or earthquake). A “peril” is an insurance term which refers to a specific type of risk — in other words, the reason for your loss. Some insurance policies only cover the perils listed in the policy, while others insurance policies cover everything that is not specifically excluded. Make sure you understand exactly what is and what is not covered by your home insurance policy.