What Mortgage Insurance Is and Why You Need It

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Last Updated:Aug 25, 2023

What Mortgage Insurance Is and Why You Need It

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A common misconception about buying a house is that a 20% down payment is required.

Lenders prefer 20% down as a form of security so that if the borrower defaults, the lender would at least have 20% of the mortgage paid. The bank can ultimately get the house, too, since it’s collateral on the loan, but banks prefer money over possibly losing money on selling a home.

Plenty of home loans require as little as 3% down from the buyer, leaving a 17% gap between money paid and what the bank prefers to have.

Mortgage insurance can make up that difference and allow a home shopper to become a home buyer and qualify for a loan.

In this article

What is mortgage insurance?

The home buyer pays for mortgage insurance. Lenders often require it before approving a home loan. The higher the down payment you have, the less mortgage insurance you’ll need to buy.

If you default on the loan, the mortgage insurance pays the lender up to the insured mortgage amount.

You’d think that buying insurance protects you. But it doesn’t in this case. And this is key. Mortgage insurance protects the lender, not the borrower, against potential losses.

You’re buying mortgage insurance to compensate the lender for taking on the higher risk of lending to you instead of someone with a larger down payment.

There are two main types of mortgage insurance, which we’ll get to soon, but the main one is called private mortgage insurance (PMI), and it typically costs 0.5% to 1% of the entire loan amount annually.

For example, a 1% PMI fee on a $100,000 loan is $1,000 per year, or $83.33 per month added to a mortgage.

Costs vary depending on the down payment, length of the loan, credit score, type of mortgage, and other criteria.

When your equity in the home reaches 20%, you can cancel PMI and no longer have to pay it. That’s the policy of most lenders. Some, however, require PMI to be paid for a certain time, even if you’ve reached the 20% equity threshold.

PMI was tax-deductible until 2017 for some families, but that deduction ended in 2018.

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Types of mortgage insurance

Private mortgage insurance is the most common type. It covers conventional mortgages on loans not guaranteed or insured by a government agency. PMI allows down payments as low as 3%.

The second type of mortgage insurance is FHA mortgage insurance premiums or MIP. It’s for FHA loans, which usually require 3.5% down.

Mortgage insurance can be paid in a few ways:

A monthly fee paid to your lender (most common)
Up front, as a lump sum
By your lender (slightly higher interest rate)
A hybrid of a lump sum and monthly amount

Avoiding mortgage insurance

Paying mortgage insurance can seem like giving money away. It doesn’t help you build equity, and it’s not providing you with any insurance payout.

Instead, it puts money in the pocket of an insurer and, ultimately, the lender if you default on the loan.

You can avoid paying mortgage insurance by coming up with a 20% down payment on a home. But that isn’t easy.

One option is to get a piggyback mortgage. It’s a second and smaller mortgage to get you to the 20% down payment. It can work by what’s known as an 80/10/10 agreement:

80% of the total property value in the first loan
10% in a down payment
10% in a piggyback loan

To buy a home for $200,000 equates to a $160,000 first mortgage, a $20,000 down payment, and a $20,000 piggyback loan.

You pay the second loan back just as you would the first loan.

Some piggyback loans, however, have higher interest rates because they’re considered risky. They increase a buyer’s total loan amount and the typical loan-to-value ratio (LTV) of 80% to 90%, exposing the lender to more risk.

Piggyback loans could also be due sooner, in 15 or 20 years, instead of the standard 30-year mortgage. They may also be adjustable loans or require balloon payments.

Before the housing crisis of the early 2000s, many lenders offered piggyback loans of 20% on top of the first mortgage of 80%. The entire down payment was paid with a second mortgage, allowing the buyer not to have to put any money down.

That changed after the housing crisis when home values dropped, and many homeowners found their homes worth less than what they paid for the home. It’s called being underwater on loan.

Since then, piggyback loans have been limited to 90% LTV, meaning a 10% down payment is required.

Having two loans also requires paying closing costs on two loans, such as origination and administrative fees.

If that is too expensive for you and you don’t want to pay mortgage insurance, your best option may be to wait until you can afford a bigger down payment to buy a house.

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