For many people, buying a home is the most expensive single-item purchase they will ever make. And in order to fund this purchase, most homebuyers have to borrow money (from a bank or other lending institution) in the form of a mortgage loan.
As a result, it is little surprise that the mortgage lender needs some sort of assurance ― even beyond the option of foreclosure and selling the property ― that they will receive remuneration if the borrower defaults on the loan. In general, if the down payment is less than 20% of the home’s price, the lender will require the borrower to pay mortgage insurance premiums to ensure the lender against potential losses.
There are two main sources for mortgage insurance: private companies and the government. Even though the premium payments are similar for both types of insurance, there are some notable differences.
Private Mortgage Insurance (PMI)
PMI represents mortgage insurance that is purchased through the private sector. You cannot get PMI for government mortgage loans, such as FHA loans or VA loans ― instead, you will need to obtain insurance through the government. If you are approved for a conventional loan (i.e. a loan not backed by the government), you may be subject to PMI.
Some types of private mortgage insurance allow you to pay the entire PMI premium (for the life of the loan) up-front in a single payment. Another option is to pay the PMI premium up-front for the first year, and then annually from an escrow account thereafter.
The most popular choice is to pay monthly PMI premiums along with the monthly mortgage payments. This method allows you to remit monthly insurance premiums until you reach a sufficient Loan-to-Value Ratio (usually 80%), at which point the PMI may be cancelled. In most cases, this arrangement will save you more money on mortgage insurance (than a single premium payment).
Government Mortgage Insurance
Government mortgage loans, such as FHA loans, require the borrower to pay for government mortgage insurance. The stipulations for government mortgage insurance are generally more precise than for PMI. Government insurance premiums are based on the mortgage loan amount and charged to the borrower each month ― no single premium option. However, government mortgage insurance may also come with a 1.5% up-front fee that is added to the loan.
The LTV ratio requirements are slightly different for government insurance than PMI. While a borrower may request to cancel PMI once their LTV ratio reaches 80%, government mortgage insurance usually cannot be cancelled until the LTV ratio reaches 78% on mortgages longer than 15 years. If your term is less than 15 years, different rules apply ― you are generally rewarded for choosing a shorter loan term.
Your mortgage insurance will depend on the type of loan you get and the size of your down payment. Make sure you understand the insurance options, as well as how the premiums will affect your overall budget, before making any permanent decisions.