Mortgage Insurance: What it Does and How it Works
Private Mortgage Insurance (PMI) is a handy tool if you wish to purchase a home with a low down payment. However, the price of PMI raises your overall loan cost. This article explains the following points:
- What is PMI
- The different types of mortgage insurance
- The major insurers
- The cost of PMI
What is Private Mortgage Insurance?
Private mortgage insurance is a confusing name for the borrower. We are all familiar with different types of insurance, such as home, auto, and life insurance. All of those insurances help reduce financial risks we face. However, private mortgage insurance is different.
- Private mortgage insurance is: A financial tool to help you buy a house if you have a small down payment.
- Private mortgage insurance is not: An insurance policy covering you if you cannot make your payments, or protection if you default.
Mortgage insurance is paid to the lender if you default on your home loan. The borrower pays the insurance premium, and the lender is the beneficiary. This lender protection opens up the possibility of you qualifying for a low down-payment loan the lender would otherwise not consider.
Three Major Types of Mortgage Insurance
Mortgage insurance comes in different packages, depending on your loan type. There are three major types of mortgage insurance:
- PMI: PMI is generally offered on conventional loans. The borrower pays the premium according to the package offered by the lender.
- LPMI: Lender Private Mortgage Insurance is arranged by the lender directly with the insurance company. The lender passes the cost to you by increasing the interest rate and/or mortgage fees.
- MIP: Mortgage Insurance Premium program is required for FHA loans with high LTV values. FHA loans are available up to 97.5% financing and are generally more lenient in their underwriting requirements, such as credit score and debt-to-income ratio. Read the Bills.com articles for more information about FHA loans and FHA mortgage insurance to learn more.
The Major Insurers
The housing market, the mortgage market, and the mortgage insurance market have been in turmoil since 2008. Some of the major insurers have run into financial problems during 2010 and 2011. The mortgage insurance industry is big. According to the MICA (Mortgage Insurers of America) there was more than $16 billion of primary new insurance policies written from October through December 2011 totalling more than 83,000 new applications.
Here are the big mortgage insurance companies:
- Mortgage Guaranty Insurance Corp. (MGIC)
- Radian Guaranty Inc.
- Republic Mortgage Insurance Co.
- Genworth Financial Inc.
Two companies, PMI Mortgage Insurance Co. and United Guaranty Corp. ran into financial difficulties and others may join them. It is still too early to tell how the availability and cost of PMI will be affected.
Cost of PMI
You know how important it is to maintain a good credit score. This impacts your ability to get a mortgage loan or other types of credit. Credit score also comes into play when figuring the costs of your PMI.
Four Factors in Determining the Cost of PMI
Figuring out the cost of PMI is complicated, but depends on four factors:
- FICO score: In general, there are three main categories:
- LTV and Coverage Required: Loans over 80% generally require mortgage insurance. The Coverage Requirement tables are set by the LTV and length of loan. For an example see the MGIC table for standard coverage from July 2011.
- State: The state you reside in or place of purchase, which can influence the amounts offered and the types of programs available.
- Adjustments: Various adjustments are made, such as for cash-out loans, size of loan, second home (relocation lowers the premium), and term of loan
There are different payment plans for PMI. The type of plan will depend on the types of funds that you have available for closing. The various options available include payments made up front, either prepaid or rolled into the loan, annual premiums, or monthly premiums. In most cases, borrowers pay a monthly fee in addition to their principal and interest payments.
Here are some of the name of the Payment Plans:
- Monthly - zero
- Level annual
- Single premium
- Split premium
The Premium: How Much Does PMI Cost?
The premium will depend on the cost factors mentioned above and the payment plan chosen.
Here is an example based on Genworth's August 1, 2011 rate schedules, for information purposes only:
|Criteria||Example 1||Example 2||Example 3|
|Amount of Coverage||25%||25%||25%|
|Type of Loan||Fixed||Fixed||Non-Fixed|
|Length of Loan||30 years||30 years||30 years|
Running the same numbers through Radian’s rate sheet of November 1, 2011, you would be charged a lower premium, resulting in a smaller monthly payment between $7.5 to $42.5 per month.
You will pay this premium as long as the LTV is over 78%, based on the original value of the property, as set out in the HPA of 1998, as discussed in the section below. Remember, the monthly cost of PMI, does not decrease over the period of the loan, until it is canceled.
The Homeowners Protection Act of 1998 introduced a big protection for borrowers with PMI. The law protects consumers in two ways:
- The lender must inform the borrower, both at closing an in the annual statement, about their right to request the cancelation of the insurance.
- Lenders must automatically cancel the insurance, even if there is no request for borrowers who meet the minimum requirements.
Borrower Initiated Cancelation: The borrower can request the cancelation of the mortgage insurance once the loan balance is 80% of the value of the house. The borrower must be current on their payments and the lender can verify that the value of the house has not declined.
Automatic Cancelation: Once the loan balance is 78% of the original value of the house, the lender must automatically cancel the insurance. The only condition is that the borrower be current. Once these two conditions happen, the insurance will be terminated.
The cancelation clause is very important for you, because the cost of the PMI is only for that period of the loan until you reach the 78% LTV based on the original value of the house.
Comparing the Cost of PMI
PMI is a financial cost. It is not an insurance policy that covers your risk of default, or unemployment or sickness. PMI enables you to take out a loan with a low down payment. Your biggest advantage is the opportunity to get into the housing market while prices are low. If you already have money saved, then you can see if taking out
Here is an example so you can get a better idea of how much PMI costs.
|Cost of House||$250,000|
|Down Payment||$ 25,000||make sure that you have extra for all the closing costs, approximately. another 10%|
|Length of Loan||30 years Fixed Rate Mortgage|
|Bank Fees:||0.8%||This is for origination and discount points. There are other third party fees.|
|Mortgage Insurance Premium||0.54%||Based on Genworth's tables from 8-1-11 using FICO score of 720, 25% coverage, and a monthly premium.|
|Length of PMI||68 months||Assuming you are current on the loan and wait until the 78% level, based on original value.|
Based on the example above, the monthly payment of principal and interest would be $1,061.5 and the cost of PMI would be $101.25 per month for the first 68 months of the loan. To calculate the financial cost of PMI you would need to know the length of time which you will hold on to the loan. Based on the above example, excluding the bank fees, you would pay:
- Full term: 0.23% more. 4.13% with PMI versus 3.9%
- 10 years: 0.36% more. 4.26% with PMI versus 3.9%
PMI is a useful tool to buy a house with a low down payment. When looking for the right mortgage loan, it pays for you to shop around. Your lender will offer you a package including the interest rate, mortgage fees, and PMI payments. Look at the mortgage insurance companies' Web sites to see if the PMI offered is a competitive rate.