If you’re in the market for a new home but struggling to save a down payment, all is not lost. It’s still possible to purchase a home without a 20% down payment, but you will need to take on mortgage insurance.
For many US homebuyers, a 20% down payment (the amount you need to avoid mortgage insurance) just isn’t possible. With rising home prices and competing financial goals (like saving for retirement), it can be a real challenge to save enough money to avoid mortgage insurance.
According to the most recent statistics from the Realtors Confidence Index survey, 71% of first-time non-cash buyers put less than 20% down on their homes. For all of the cash buyers, the number sits at 48%. While no one wants to add mortgage insurance into the mix because it results in higher interest rates and a larger monthly payment, it does help people get into a home of their own much sooner.
In this article, we explore what mortgage insurance is and how it works. We also look at the different types of mortgage insurance that are available so you can start to determine which product is right for you.
What is mortgage insurance?
Mortgage insurance, also referred to as mortgage default insurance, is an insurance policy that protects the lender (not the home buyer) against default. There are different types of mortgage insurance including private mortgage insurance (PMI) and qualified mortgage insurance premium (MIP), which we will discuss later on in this article.
How does mortgage insurance work?
If you lose your job or experience a health issue that prevents you from working and you are unable to pay your mortgage, your mortgage insurance helps to cover the loss to your lender. Mortgage insurance is there to reimburse the lender if you default on your loan and your home goes into foreclosure. This protection helps to reduce the risk to the lender which is why they are willing to lend you money if you have less than a 20% down payment.
What does mortgage insurance cover?
It’s important you don’t confuse homeowners insurance with mortgage insurance. Homeowners insurance helps to protect you, the homeowner, in the case of a home fire or theft. Mortgage insurance covers the lender in the event that you default on your loan.
How much does mortgage insurance cost?
While mortgage insurance makes it easier to obtain a mortgage, it also makes it more expensive. On average, mortgage insurance is around 0.5% to 1.5% of the annual loan amount. So, if you put a 5% ($16,000) down payment on a $320,000 home you would need a $304,000 loan. This would cost you between $1,520 and $4,560 annually. The exact cost of home mortgage insurance depends on a number of factors including:
- Mortgage amount
- Down payment amount
- Type of property
- Type of mortgage loan
- Credit score
Who needs mortgage insurance?
Any prospective homeowner with a down payment of less than 20% of the home purchase price is required to get mortgage insurance. For many Americans, saving a down payment of 20% or more is not financially feasible. The option of mortgage insurance permits those that don’t have a large enough down payment to purchase a home. This is because mortgage insurance lowers the risk of default to the lender and allows the homebuyer to purchase a home with as little as a 5% down payment, or even 3% in certain cases.
To highlight this with an example. The average home value in the United States is approximately $320,000, according to recent data from Zillow. A 20% down payment on a $320,662 home is $64,000. An unrealistic amount for many first-time homebuyers. At 5%, a down payment of $16,000 is required. Still costly, but more attainable.
Private Mortgage Insurance (PMI) vs. Mortgage Insurance Premium (MIP)
There are two types of mortgage insurance: Private mortgage insurance (PMI) and Mortgage Insurance Premium (MIP).
Private mortgage insurance
Private mortgage insurance is the type of insurance that is associated with a conventional loan (a loan that isn’t backed by a government program) and is required if you have a down payment of less than 20% of the purchase price.
Private mortgage insurance is provided by a private insurance company and its purpose is to protect the lender, not you as a homeowner. The cost of PMI depends on factors like your credit score, down payment amount, and the lender but you can expect it to cost somewhere around 0.5% to 1% of your annual home loan amount.
Mortgage insurance premium
Mortgage Insurance Premium is taken out for loans backed by the Federal Housing Administration (FHA). Most FHA home loans require the purchase of a mortgage insurance premium (MIP). Your FHA loan MIP typically involves two payments and the cost of these payments are dependent on the size of your loan.
First, there is an upfront premium that is due at closing. This is 1.75% of your loan value.
Second, there is an annual payment which is included in the cost of your monthly mortgage payments. Your annual payment will vary based on the cost of your loan, the size of your down payment, as well as your mortgage term, but are usually somewhere in the range of 0.45% to 1.05% of your loan value.
What are the main differences between a PMI and MIP?
The main difference between a PMI and MIP is that they are each associated with a different type of mortgage loan. PMI is associated with conventional loans and MIP with FHA loans. A PMI typically offers more flexibility and lower rates than a MIP. However, an FHA loan is usually easier to qualify for, especially for first-time homebuyers or those with lower income or lower credit scores.
The other major difference is with the payment structure. A MIP requires an upfront premium amount at closing while the PMI does not.
A third difference between the two is in how long you are required to pay for mortgage insurance. With a conventional loan, you are only required to pay PMI until your home equity hits 20%. With an FHA loan, you are required to pay MIP for at least 11 years (with a down payment of 10% or greater) and perhaps the entire length of your loan. It depends on the size of your down payment. The best way to get rid of MIP is to refinance with a non-FHA loan once you have accumulated 20% equity in your home.
Types of Private Mortgage Insurance
For home buyers looking for a conventional loan, there are four types of private mortgage insurance to choose from including:
Borrower-paid mortgage insurance
The most popular type of PMI is borrower-paid mortgage insurance (BPMI). Borrower-paid mortgage insurance can be a good choice for those who don’t know how long they want to stay in their home because there is no up-front lump sum cost.
With BPMI, you are required to make monthly insurance payments. You can choose to include your PMI in your monthly mortgage payment or pay it separately. Payment continues until you have 22% equity in your home. You can request to cancel your BPMI payments when you reach 20% equity, but it’s up to your lender to decide if they will accept your request.
To be considered, you need to be current on your payments, have a solid repayment history, and can’t have any liens on your home. Another option that may allow you to cancel PMI sooner is refinancing. Before you decide to refinance, make sure you compare the cost of refinancing to the cost of continuing to pay your PMI.
Single premium mortgage insurance
If you like the idea of providing an up-front lump sum cost for your insurance premium, removing the need for a monthly PMI payment, then you might be interested in single premium mortgage insurance (SPMI).
Since you make one lump-sum payment right off the bat, your monthly PMI payments will typically be lower. This can allow you to qualify for more money in which to finance your home. However, there is some risk involved with an SPMI if you don’t stay in your home for more than a few years since the lump sum payment is non-refundable.
The reason most people need PMI is that they don’t have a 20% down payment. So, coming up with a lump sum payment for the SPMI can also be difficult. One way around this is to try and negotiate the SPMI payment into the cost of the home.
Lender-Paid Mortgage Insurance
Lender-paid mortgage insurance (LPMI), is just what it sounds like. Your lender pays your mortgage insurance upfront. However, you are still on the hook to pay the lender back over the course of the loan in the form of slightly higher interest payments.
With LPMI, you don’t have the option to cancel your mortgage insurance when your equity reaches 78%. This is because the insurance is built into your monthly payments for the duration of your loan. In order to reduce your monthly payments, you will need to consider refinancing.
The benefit of an LPMI is that it can result in lower monthly payments, even if your interest payments end up being a little bit higher. Lower monthly payments might allow you to qualify for a larger loan.
Split-Premium Mortgage Insurance
Split-premium mortgage insurance (SPMI) combines aspects of the borrower-paid mortgage insurance and single-premium mortgage insurance. With the SPMI, borrowers have the option to pay part of the mortgage insurance upfront, as a lump-sum payment (similar to the SPMI) and they can pay part of their insurance in the form of monthly payments (like the BPMI).
You might be wondering why anyone would want to do this. Well, by allowing part of the payment to be paid in the form of a lump sum, and part to be paid in monthly payments, the borrower isn’t required to have as much money available upfront at closing and the monthly payments are lower. It’s like getting the best of both worlds.
The SPMI is often used by borrowers who have a high debt-to-income ratio. By paying part of the mortgage insurance upfront, it helps to lower their monthly payments, allowing them to potentially qualify for a larger mortgage loan.
Do I need mortgage insurance?
Unless you have a down payment of 20% or more of the purchase price of the home you intend to buy, you will need to purchase mortgage insurance if you are taking on a conventional loan.
Those taking on an FHA home loan will need to pay a mortgage insurance premium regardless of the down payment.
How to avoid mortgage insurance?
If you want to avoid paying home mortgage insurance and you don’t have a minimum down payment of 20%, then you have a few options.
Save more money
Option one is to hold off on homeownership and continue to save until you have a large enough down payment to avoid mortgage insurance. You can attempt to increase your income by picking up more shifts or taking on a side hustle. Additionally, you can review your budget to see where you can cut expenses to put more savings into your down payment fund.
Consider a piggyback mortgage
Another option is to take on a piggyback mortgage, also known as a second mortgage. A piggyback mortgage is a home equity loan or home equity line of credit (HELOC) that you take on at the same time as your primary mortgage.
The purpose of a piggyback mortgage is to allow prospective homeowners who have less than a 20% down payment to borrow money, in addition to their main mortgage, so they can avoid mortgage insurance. Here’s an example of how it works.
With a piggyback mortgage, you take out a traditional mortgage to cover the first 80%. Then you use a piggyback loan (home equity loan or HELOC) to cover the next 10%, and the final 10% is your down payment. By taking out the 10% piggyback loan in addition to your 10% down payment, you have 20% to put towards your down payment, which means you can avoid mortgage insurance.
Before taking on a piggyback loan, it’s important to weigh the pros and cons. The main pro is that a piggyback loan can help you avoid the extra cost of mortgage insurance without having to save 20%. However, in some cases, the piggyback loan could end up costing you more than mortgage insurance. Make sure you do your research to determine which options make more financial sense.
A piggyback loan can also be difficult to qualify for. You typically need a very good (740 - 799) to exceptional (800-850) FICO credit score to qualify.
If you need to refinance at any point, a piggyback mortgage can make the process more complicated. In some cases, you might have to pay off the second loan before you can refinance.