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Mortgage Insurance: What is It and How Does It Work?

Compare Different Loan Types and the Cost of Your Payments

When you want to buy or refinance a home, you may be required to pay for mortgage insurance as part of your monthly payment. Whether or not you need to pay for mortgage insurance depends on the type of loan you want, how much you put down, and other factors we’ll discuss in this article. Understanding how mortgage insurance works can help you compare loan options and have a better idea of the costs involved in homeownership.

What is Mortgage Insurance?

Mortgage insurance is a type of insurance policy that protects the lender in case a borrower defaults on a loan. It’s typically required when a buyer makes a smaller down payment, since lower upfront equity is considered riskier to lenders. While mortgage insurance exists to protect the lender, it also helps make homeownership more accessible by allowing homebuyers to qualify for a mortgage with less money down.

PMI vs. MIP: Key Differences

Private mortgage insurance (PMI) and mortgage insurance premium (MIP) are both types of mortgage insurance that serve similar purposes, but they apply to different types of loans and have different rules. The table below highlights the main differences, which we’ll explore more in-depth later in this article.

	Private Mortgage Insurance (PMI)	Mortgage Insurance Premium (MIP)
Applicable Loan Type	Used with conventional loans when the down payment is less than 20%.	Required for FHA loans, regardless of down payment amount.
Cost	Cost varies based on credit score, loan amount, and down payment size.	Cost is set by the FHA and includes upfront and annual premiums.
Ability to Cancel	Can usually be canceled once you reach 20% home equity.	Typically lasts for the entire life of the loan, unless a 10% or more down payment is made, in which case, MIP will end after 11 years.

How Does Mortgage Insurance Work?

Mortgage insurance protects the lender, not the borrower, if the borrower doesn’t make their mortgage payments. Because low down payment loans are considered high risk, lenders require mortgage insurance as a means of reducing potential losses.

The cost of mortgage insurance is an added expense that’s usually paid as part of your monthly mortgage payment, though some loans allow you to pay it as a lump sum or as part of an upfront premium. While it increases your monthly costs, mortgage insurance can make it possible to buy a home sooner even if you don’t have a lot of cash for the down payment.

How the Cost of Mortgage Insurance Is Determined

The cost of mortgage insurance depends on several factors, including the type of insurance required and details about your loan and financial health.

Loan type: Different types of loans have different mortgage insurance requirements. For example, FHA loans use MIP, while conventional loans require PMI
Loan term: Longer loan terms can result in higher overall mortgage insurance costs.
Credit score: Borrowers with higher credit scores typically pay lower mortgage insurance rates.
Down payment: A larger down payment reduces lender risk and can lower mortgage insurance costs.
Fixed vs. adjustable interest rate: Adjustable-rate loans may carry higher mortgage insurance costs due to higher risk compared to fixed-rate.
Loan-to-value (LTV) ratio: Higher LTV ratios generally mean higher mortgage insurance rates.

Keep in mind that this list isn’t exhaustive, as lenders may consider additional factors when determining your mortgage insurance rate.

Types of Mortgage Insurance

As we mentioned earlier, the type of mortgage insurance that is used varies by the type of loan.

Private Mortgage Insurance (PMI) for Conventional Loans

If you make a down payment of less than 20%, you’ll have to pay for private mortgage insurance (PMI) when you buy a house with a conventional loan. If you make a down payment of 20% or more, you don’t need to pay for PMI.

The cost of your PMI payments will depend on your credit score, as well as your down payment. This cost is typically between 0.2% and 2% of your mortgage loan amount. Once your home’s equity reaches 20%, you can often request to have the PMI canceled.

When you’re refinancing your conventional loan, you won’t need to pay for PMI if your equity is 20% or more.

FHA Loan Mortgage Insurance Premium (MIP)

Federal Housing Administration (FHA) loans always include an upfront mortgage insurance premium (UFMIP) and monthly insurance premiums (MIP), regardless of down payment amount. The upfront fee is typically about 1.75% of the loan amount. The monthly premiums depend on the mortgage term and other factors and often cost between 0.15% and .75% of the loan amount.

You’ll also need to pay upfront and monthly insurance premiums when you refinance an FHA loan. If you’ve received your current FHA loan within the past three years, you may be eligible for a refund on a portion of your previous UFMIP when you refinance.

USDA Loan Guarantee Fees

Mortgage insurance for USDA loans is called a guarantee fee. Like FHA loans, USDA loans have an upfront fee and monthly payments that you must pay, regardless of the down payment amount. The upfront guarantee fee is 1% of the initial loan amount, and the annual fee is 0.35% of the average annual unpaid principal balance on your home. USDA loan refinancing also comes with guarantee fees you’ll typically need to pay.

No Mortgage Insurance for VA Loans

Although the Department of Veterans Affairs (VA) doesn’t require mortgage insurance, VA loans usually come with a one-time funding fee. Some disabled veterans and surviving spouses may qualify for an exemption from this fee.

The funding fee is determined based on the amount of your down payment and other factors. For example, your funding fee may be lower if this is your first time buying a home with a VA loan. You can often add your funding fee to your total loan amount instead of paying it in cash at closing.

If you’re refinancing your VA loan into a lower rate through a VA Interest Rate Reduction Refinance Loan (IRRRL), also known as a VA streamline refinance, you’ll typically need to pay the VA funding fee again. However, this fee is just 0.5% of the loan amount, and you can often add it to your new loan balance, rather than paying it in cash at closing.

How to Avoid Mortgage Insurance

There are a few strategies that can help you avoid paying mortgage insurance altogether, depending on your financial situation and loan eligibility.

Make a down payment of 20% or more: Putting at least 20% down on a conventional loan typically eliminates the need for PMI.
Use a VA or USDA loan: These government-backed loans don’t require traditional mortgage insurance, though they have specific eligibility guidelines and may include other fees.
Consider a “piggyback” loan: This involves taking out a second mortgage to cover part of the down payment, which can help you avoid mortgage insurance but can result in greater overall costs, higher interest rates, and difficulty refinancing.
Lender-Paid Mortgage Insurance (LPMI): With LPMI, the lender covers the mortgage insurance cost in exchange for a higher interest rate.
Cancel as soon as you’re able: You can usually remove PMI once you reach 20% equity in your home.

Mortgage Insurance FAQs

Below are answers to some of the most common questions homebuyers have about mortgage insurance.

Do I Need Insurance on My Mortgage?

You typically need mortgage insurance if you make a down payment of less than 20% on a conventional loan or use an FHA loan. Lenders require it to reduce their financial risk.

What Does Mortgage Insurance Cover?

Mortgage insurance covers the lender’s losses if a borrower defaults on the loan. Unlike homeowners insurance, which protects your home and belongings, mortgage insurance is not designed to provide protection for the homeowner.

Is It Better to Pay PMI or Put 20% Down?

Whether it’s better to pay PMI or put 20% down depends on your financial goals and timeline. Paying PMI may allow you to buy a home sooner than you otherwise would, while making a down payment of 20% or more can reduce long-term costs.

How Much Does Mortgage Loan Insurance Cost?

Mortgage insurance costs vary based on loan type, credit score, and down payment. In general, it ranges from a small percentage of the loan amount per year, usually spread out across monthly payments.

Final Thoughts: Mortgage Insurance Can Make Homeownership More Accessible

Mortgage insurance can increase your monthly payment, but it also opens the door to homeownership for buyers who may not have enough savings for a large down payment. Knowing how mortgage insurance works, the types of insurance, and how to avoid or remove it can help you make more informed decisions when it comes to taking out a mortgage. If you’re ready to take the next step, consider getting prequalified today to explore your options.