Eric Newman has a great video on YouTube about mortgage insurance. I would encourage you to check it out however I want to provide a bit more meat. I would like to show you how this works by showing you an example and explain how to avoid mortgage insurance.
No one likes mortgage insurance. No one wants mortgage insurance. But, mortgage insurance is a good thing. I will tell you why. If it weren’t for mortgage insurance we would all need to put 20 or 30% down when we purchased a home. It would just be too risky for the banks to lend up to 90%, 95% or even 100% of the price of the home. This is why mortgage insurance exists.
Imagine mortgage insurance as a float. Mortgage insurance is a float of the top X% of your mortgage. In the case you default (foreclosure, for example) the mortgage insurance company pays the lender this top whatever percentage to reduce the financial hit to the bank. The mortgage insurance company and the bank therefore share the risk allowing for lower down payments.
I shared the four major loan programs previously so I wont go into detail here but I will touch on them briefly from the mortgage insurance perspective:
USDA has two forms of mortgage insurance. They have an up-front guarantee fee (may be financed into the mortgage) and an annual fee (paid monthly). USDA does not allow for any variations to their mortgage insurance and therefore it can not be avoided. Due to these restrictions on USDA we will not be discussing how to avoid mortgage insurance on USDA mortgages.
VA has no monthly mortgage insurance but does require a funding fee (paid up-front or added to the loan balance) in most cases. The amount of the funding fee varies based on the type of military service and whether you have used your VA benefits previously for a mortgage. The only way to avoid the VA funding fee is if the VA provides an exemption due to a service related disability. Because VA does not have any monthly mortgage insurance we will not discuss how to avoid mortgage insurance related to VA loans.
FHA, similar to USDA, has two forms of mortgage insurance – up-front (may be financed) and monthly. The amount of monthly mortgage insurance and the length of time it remains on the mortgage varies based on the loan payment and the length, or term, of your mortgage. Just like USDA there are no ways to avoid paying monthly mortgage insurance on FHA mortgages and therefore will not be discussed in this post.
Finally, the mortgage product we will be focusing on today. Conventional mortgages require mortgage insurance whenever the loan-to-value exceeds 80% (down payment less than 20%). There are a variety of ways to pay mortgage insurance on a conventional loan and some ways to avoid paying it monthly. Conventional mortgages and the methods in which mortgage insurance can be paid, or avoided, will be discussed in this post.
Monthly, Single, or Lender
There are three main ways to pay mortgage insurance. You can pay it monthly (the most common). You can pay it up-front, at closing. Unlike USDA, VA and FHA loans you can not add this up-front cost of mortgage insurance to your mortgage balance. Lastly, you can let the lender pay it. WHAT?! Wait a second, I can let the lender pay my mortgage insurance for me? Yep, you can but it isn’t quite as good as it sounds but it is still a very good option.
To help us in comparing these options let’s put together a quick scenario. This is something I made up off the top of my head to give us a situation to compare these options. All mortgage insurance is based on several factors including loan to value, credit score, loan amount and property type (similar to mortgage rates). Here is the example scenario we will work with:
- Purchase (as opposed to a refinance)
- 95% loan-to-value (5% down payment)
- 734 credit score (yep, I just made it up)
- $274,876 loan amount (still just grabbing numbers out of thin air)
- Single Family Home
So let’s compare…
In this scenario monthly mortgage insurance would be at a cost of about .75% (still just an example – to find out what your mortgage insurance cost would be contact a licensed mortgage professional). In other words your monthly mortgage insurance is your loan balance multiplied by .75% and then divided out monthly. So, with our scenario above we would calculate it as follows:
$274,876 X .75% / 12 = $171.80/mo
I am not a fan of single premium mortgage insurance. It is expensive! But let me show you. Single premium mortgage insurance in this situation would be about 2.25% (just an example). Here is the calculation:
$274,876 X 2.25% = $6,184.71
This cost would be added to your closing costs and due at closing. By paying this up-front you avoid monthly mortgage insurance. Does it make sense? Well, it depends on how long you will live in the home without refinancing. To calculate the break-point where you benefit from paying it up-front you simply take the total single premium cost and divide it by the monthly mortgage insurance cost above to get he number of months it would take to get your money back through monthly savings.
$6,184.71 / $171.80 = 36
The up-front cost is earned back at a rate of $171.80/mo (since you’re not paying monthly MI) and therefore you would break even at month 36. After 36 months you are actually realizing a savings of $171.80/mo. But do you have an extra $6,184.71 for your closing costs? If you did you would have probably put more money down, right? Let’s look at the last option.
Lender Paid Mortgage Insurance
Lender paid mortgage insurance (LPMI) is similar to single premium only the lender pays the single premium, not you. The cost of lender paid mortgage insurance is about 2.8%. But, we don’t pay it up front. Instead we increase the interest rate. By how much? It depends on your unique situation. We will use an increase to your rate of about .625%(this varies significantly based on your unique situation). Is this the way you should go? It depends. The factors that play into determining whether LPMI is the right direction for you or not is different for every customer.
Your mortgage professional should be able to calculate a break-even point for you based on when the monthly mortgage insurance would drop off (yep, it drops off in time) versus the up-front savings you would realize by a lower monthly payment on the LPMI options compared to monthly.
Can you avoid mortgage insurance? Kinda. If you are putting less than 20% down you are going to have to pay it in some form or another but you can structure it in a way so you don’t have to pay monthly mortgage insurance. Which path you should take will depend on your situation. The best advice I can give you is to discuss this with your mortgage professional and have them assist with calculating your break-even point on these options. If I can assist you, please feel free to contact me.