If you lend a large amount of money to someone with a less-than-perfect borrowing track record, you'd want a guarantee that you'd get repaid one way or another. This is the underlying principle behind mortgage insurance. Although mortgage insurance protects lenders from loss, you may consider it a nuisance. It is, after all, another cost you have to shoulder in order to realize your dream of becoming a homeowner. But if it didn't exist, many people probably wouldn't qualify for loans at all until they had higher down payments. Many people find paying mortgage insurance premiums a better option than waiting several years until they have a high enough down payment to avoid it. While there are many different kinds of mortgage insurance, this article looks at the basics of FHA mortgage insurance.
TUTORIAL: Mortgage Basics
- FHA mortgage insurance protects lenders from losses that result from default.
- Borrowers with an FHA loan must purchase FHA mortgage insurance.
- Mortgagors must pay an up-front mortgage insurance premium of 1.75% plus annual premiums—both of which are based on the value of the loan.
- The length of time you must pay for FHA mortgage insurance depends on your amortization period and your loan-to-value ratio.
FHA Mortgage Insurance: An Overview
Federal Housing Administration loans are attractive to many consumers, especially first-time homebuyers. That's because they have lower down payment requirements—as low as 3.5%—as well as lower thresholds for income and credit. This means someone with a credit score as low as 580 may qualify.
All FHA loans require borrowers to take out mortgage insurance especially when they put down less than 20%. FHA mortgage insurance protects the lender because borrowers—especially new ones—pose a higher risk of default when they have minimal equity in their homes. In essence, you don't have that much to lose by walking away and letting the bank foreclose on the property.
The Federal Housing Administration (FHA) requires two types of mortgage insurance on FHA loans. Borrowers must pay up-front mortgage insurance (UFMI)—1.75% of the loan balance—along with annual mortgage insurance premiums based on the total value of the loan. Annual MIPs range anywhere from 0.8% to 0.85% for base loan amounts of $625,500 or less. For those exceeding this amount, the annual MIPs vary between 1% and 1.05%. These rates apply to loan terms of more than 15 years. Mortgages that are financed for 15 years or less come with rates of 0.45% to 0.95%.
To demonstrate, here's how much you'd pay in FHA mortgage insurance with a $300,000 loan:
- Mortgage amount: $300,000
- Down Payment: $10,500 (3.5% of $300,000)
- Loan Amount: $289,500
- UFMI: $5,066.25
- Annual MIP: $2,460.75 each year or $205.06 per month
Keep in mind that this scenario assumes you pay the UFMI right off the bat. But you do have the option to roll the amount into your total mortgage amount. It's a good idea to pay it in full at the beginning if you can afford to do so. But if you decide to include it in your loan, you'll pay more in the long run. Not only does it increase your loan amount, but it also increases your annual mortgage insurance premium payment as well.
FHA Mortgage Insurance Terms
According to the U.S. Department of Housing and Urban Development (HUD)'s website, the length of time FHA mortgage insurance premiums must be paid vary based on the amount and length of the mortgage. A loan-to-value ratio (LTV) equal to or less than 90% requires mortgage insurance for 11 years. A borrower with an LTV greater than 90% must pay premiums for the entire length of the mortgage.
When you first start paying your mortgage, you're at a higher risk of default, so your premiums will be higher. That's because, as mentioned above, you don't have much equity built into your home. So you only lose the $10,500 down payment if you default in the first year on that $300,000 home. Your premium payments decrease the longer you pay your mortgage. You'll be less likely to want to leave your home and default on your loan later on.
Avoiding or Getting Rid of FHA Mortgage Insurance
Because FHA mortgage insurance adds a significant expense to the cost of homeownership, you're probably wondering if there's anything you can do to reduce or avoid it, and at what point are you allowed to get rid of it.
The easiest way to avoid mortgage insurance, of course, is to put down 20%. You can do this by waiting to buy until you've saved more, or in some cases, by purchasing a less-expensive property. Of course, if you're looking at an FHA loan with 3.5% down, you're probably walking a fine line between being able to afford any mortgage at all and having to keep renting.
If home prices appreciate significantly after you buy, you may be able to refinance your way out of PMI. For this to work, your home's value will need to have appreciated enough to give you 22% equity in the home. If you can't refinance to increase your LTV ratio, consider paying down your principal balance. Not only will this help you get rid of mortgage insurance faster, but it will also help you pay your house off faster, reducing the amount of interest you'll pay over the long run. If you take this route, you will need to contact your lender to get your mortgage insurance canceled.
Some lenders may offer special loan programs that don't require monthly mortgage insurance premium payments, despite allowing a low down payment. So it's important to shop around.
Your lender is supposed to automatically drop mortgage insurance when you hit the appropriate loan-to-ratio value.
FHA vs. Private Mortgage Insurance (PMI)
There is an alternative to FHA mortgage insurance—private mortgage insurance (PMI). You may be required to buy PMI as a condition if you have a conventional mortgage. As suggested by the name, it is provided by a private insurance company and is arranged by the lender. Just like FHA mortgage insurance, PMI protects the lender, not the borrower.
You must purchase PMI if your down payment is less than 20% of the total loan. Many lenders also require PMI when you refinance your mortgage with a conventional loan and there's the amount of equity is less than 20% of the property value. But there's a big difference between FHA mortgage insurance and PMI—not all lenders require an upfront mortgage insurance payment.
PMI can cost anywhere between 0.5% to 1% of the total loan value annually. So a mortgage of $200,000 will cost you as much as $2,000 more each year at the maximum rate of 1%. Of course, your rate depends on your credit score—the better your credit, the lower the rate. If your credit score is lower, you will need a larger down payment before you're offered any type of insurance.
FHA mortgage insurance only requires a minimum credit score of 580 to be eligible for a 3.5% down payment, but most lenders require a credit score of 620 to 640 which still allows you to buy a home sooner. So if you have to have mortgage insurance, FHA mortgage insurance can be the lesser of two evils.
The Bottom Line
When considering a low down payment loan, think about whether the extra cost of both the up-front mortgage insurance and the monthly mortgage insurance premiums are worth it to you to get a house sooner. It's hard to calculate whether you'll win or lose financially in the long run with this arrangement since you can't predict what housing appreciation rates will be between the time when you have 3.5% to put down and the time when you have 20% to put down. You also can't predict how many years it would take you to save the extra 16.5% because incomes and expenses can change. For these reasons, it may be best to decide on a psychological basis whether you are comfortable with paying the extra money required for mortgage insurance in order to have a place to call your own.