Mortgage insurance allows homebuyers to purchase homes with down payments of less than 20%.
This credit enhancement tool involves paying an additional charge with your mortgage to protect the lender from financial losses if the home goes into foreclosure.
With how hard it can be to save for a large down payment, mortgage insurance is often the key to buying a home. Still, buyers considering a home purchase that would require mortgage insurance should carefully consider whether the extra monthly cost is worth it.
Table of contents
- Mortgage insurance explained
- Why do you need mortgage insurance?
- What are the types of mortgage insurance?
- Advantages of mortgage insurance
- Cons of mortgage insurance
- 6 steps to take to prepare for mortgage insurance
Mortgage insurance explained
Mortgage insurance is a type of insurance that protects lenders if a borrower defaults on their mortgage loan. It is typically required for homebuyers who make a down payment of less than 20% of the home's total price.
The monthly cost of the insurance is typically a percentage of the loan amount, which is added to the borrower's monthly mortgage payment. The insurance payment can vary depending on:
- Type of loan
- Size of the down payment
- Creditworthiness of the borrower
Usually, once you reach 20% equity in your home, you no longer need to pay mortgage insurance. At that time, you should request that your lender remove it.
Why do you need mortgage insurance?
If you want to buy a property but don't want to — or can’t — spend 20% on a down payment, then mortgage insurance is likely necessary.
Mortgage insurance is almost always required for conventional home loans when a buyer’s down payment is less than 20% of the home price. Some lenders have policies that allow borrowers to make a down payment of less than 20% without the need for mortgage insurance. However, these “no-PMI loans” usually come with higher interest rates.
So if you don't have the cash to pay for a large down payment, then you’ll need mortgage insurance to have a chance to still buy the home you want.
Government-backed loan programs, such as Federal Housing Administration (FHA) loans, have mortgage insurance requirements as well, each with a unique set of rules.
What are the types of mortgage insurance?
There are two main types of mortgage insurance: Private mortgage insurance (PMI) and mortgage insurance premium (MIP).
Private mortgage insurance (PMI)
Private financial institutions can require PMI for homebuyers who cannot make at least a 20% down payment. The cost of PMI is typically added to the monthly mortgage payment and can range from 0.3% to 1.5% of the loan amount per year. The exact cost of PMI will depend on a variety of factors, including your credit score.
You can eventually cancel your PMI once you’ve built up enough equity in your home. This typically happens when you’ve paid down your loan enough to reach a loan-to-value ratio of 80% or less. If the value of your home rises, that can also help you reach the equity threshold sooner, but an appraisal would likely be required.
Most PMI falls under what’s known as borrower-paid mortgage insurance (BPMI), which, as the name implies, means it's the borrower’s responsibility to cover the fees. Usually, this PMI is paid monthly, but you may also have the option to pay a one-time premium for mortgage insurance instead. This is known as single-premium mortgage insurance.
There’s also lender-paid mortgage insurance, where a lender covers the insurance costs but in exchange, you’ll have a higher mortgage rate, so your monthly expenses are still higher than they would be without insurance.
Mortgage insurance premium (MIP)
MIP is required for FHA loans. These loans are government insured and are designed to help first-time homebuyers and those with lower incomes buy homes.
The cost of MIP is typically added to the monthly mortgage payment. In 2023, the annual cost was lowered to 0.55% of the loan amount (for most qualifying borrowers). Unlike PMI, which you can cancel when you reach a certain level of equity in the home, MIP is usually required for the life of the loan. This means that you will have to pay MIP until you pay off the loan or refinance to a different type of loan.
Besides the monthly MIP payments, you may have a one-time charge called an upfront MIP. This payment is typically 1.75% of the loan amount, and you have the option to finance it into your loan.
Similar fees on other government-backed loans
There are two fees associated with other government-backed loans — the USDA guarantee fee and the VA funding fee — that work almost like mortgage insurance.
USDA guarantee fee
The U.S. Department of Agriculture (USDA) guarantee fee is required for homebuyers who are looking to buy a home in a rural area with a USDA loan. This type of loan is backed by the USDA and is designed to help low- and moderate-income homebuyers.
The upfront USDA guarantee fee is 1% of the loan amount, and there’s an annual fee of 0.35%.
While not technically an insurance, the guarantee fee is often grouped in the same category because it works similarly. Lenders use this fee to offset the costs associated with supplying the loan and to ensure the long-term sustainability of the USDA loan program. The fee can be paid upfront at the time of closing, or it can be financed with the loan.
VA funding fee
The VA funding fee is required for homebuyers looking to buy a home with a loan backed by the Department of Veterans Affairs (VA). This type of mortgage is available to veterans, active-duty service members and spouses of service members — active or veterans. These loans also do not require a down payment, making them a more affordable option for veterans and service members.
The VA funding fee can range from 0.5% to 3.3% of the loan amount.
Like the USDA guarantee fee, the VA funding fee isn’t technically insurance either.
Advantages of mortgage insurance
While it is an added expense, mortgage insurance has several advantages if you're trying to buy a home.
Low down payment: The biggest advantage of mortgage insurance is that it allows you to buy a home with a low down payment. For conventional loans, a down payment of 20% is typically required. Considering the current real estate market, this down payment can be quite significant. But with mortgage insurance, you could put as little as 3% down and still get the home you want.
Cancellation: You can usually cancel mortgage insurance once you’ve built up enough equity. This means your higher monthly payments are only temporary.
Cons of mortgage insurance
Like any financial product, mortgage insurance also has its drawbacks.
Additional cost: The main disadvantage of mortgage insurance is the cost. The cost of mortgage insurance is typically added to the monthly mortgage payment and can range from 0.3% to 1.5% of the loan amount per year. For some people, this added cost can be a significant burden in the long run. Make sure you weigh the pros and cons to see whether waiting longer to save up for a typical down payment makes sense for you, or if it’s better to pay potentially a few hundred extra dollars every month.
Some types of mortgage insurance (or similar fees) cannot be canceled: If you are counting on being able to cancel your mortgage insurance once you build equity, keep in mind that usually only applies for private mortgage insurance on conventional loans. Most insurance and similar fees for government-backed mortgages apply for the entire loan term regardless of equity.
6 steps to take to prepare for mortgage insurance
If you're looking to purchase a home without committing to a large down payment, you need to know how to handle mortgage insurance efficiently. Here are the next steps you should take.
1. Understand the types of loans and mortgage insurance
Know the differences between the types of mortgage insurance described in this guide to know which option applies to your home purchase. Research different loans offered by both private institutions and the government to find one that suits your needs best.
2. Review your credit score
Before you can apply for a loan with a low down payment, you'll need to review your credit score. If possible, try to improve your credit score as much as you can before applying for a home mortgage.
3. Decide on a lender
Not all lenders offer the same mortgage insurance rates and terms. Compare rates and terms from different lenders to find the best mortgage lender for you.
4. Understand the terms and conditions
Read and understand the terms and conditions of your mortgage insurance policy. This will help you understand when and how you can cancel your insurance and what the penalties are for canceling early.
5. Budget accordingly
Factor the cost of mortgage insurance into your monthly budget. This will help you understand what you can afford and ensure that you are not overreaching.
6. Keep an eye on your equity
If you're planning to cancel your mortgage insurance, keep an eye on your equity. As soon as you have enough equity in your home, you may be able to cancel your insurance and save money on your monthly mortgage payment.