July 31, 2010 1:15 PM at Loanlane in Menlo Park, CA
Mortgage Insurance Explained
Definition
Mortgage insurance allows consumers to buy or refinance a home with less than 20% equity. It is more common with home buyers, as the largest barrier to home ownership is the ability to make the down payment.
Lenders typically require that a home buyer make a 20% down payment, or that a home owner (in the case of a refinance) have 20% equity in the home. The strategy behind this thinking is that homes with more protective equity are a safer investment for the lender. This has been proven with statistics on home mortgage defaults.
What it Does
Mortgage insurance protects the lender in the event of mortgage default. The company issuing the mortgage insurance guarantees the lender that there will be protective equity. In other words, if the homeowner defaults on his or her mortgage, the lender is guaranteed that there will be enough equity in the property to A.) repay the mortgage through a subsequent property transfer, and B.) pay the associated fees of the property transfer.
If lenders were not guaranteed their loan would be covered, they would not lend, thereby putting a squeeze on the housing market.
What it Doesn't Do
Mortgage insurance does not insure the homeowner. It does not insure the property against fire, flood, or other casualty. It does not pay the loan in full in the event of the homeowner's death.
Cost
The cost of mortgage insurance depends on several factors, the most important being the amount of the loan, and the amount of equity.
The policy premium is a percentage, and this percentage is multiplied by the amount of the loan. For example, a typical premium might look like this:
$100,000
Loan Amount
X .51%
Factor
$510.00
Per Year
$42.50
Per Month
The factor used above changes depending on the amount of equity, and type of loan. For example, a loan with 5% equity would have a higher factor than a loan with 10% equity. Adjustable rate mortgages have higher factors than fixed rate loans.
Duration
Mortgage insurance must remain in effect until the investor of the loan approves of its removal. An investor will usually allow the mortgage insurance to discontinue when the equity reaches 20% . This can happen through the amortization of the loan, through market appreciation, or both. However, if market appreciation has occurred, the homeowner will be required to demonstrate to the investor the present market value of the home. This is done by having the home appraised by an appraiser, and the appraisal is at your expense.
Investors are allowed to establish reasonable guidelines regarding the discontinuance of mortgage insurance. Therefore, before you take any steps to petition the removal of mortgage insurance, it is best to contact the investor of your mortgage and request their written policy regarding the discontinuance of mortgage insurance.
Another way to remove mortgage insurance is via a refinance transaction. That is, if the home has appreciated in value, and a refinance transaction (which always includes an appraisal) shows an acceptable loan-to-value ratio, then the mortgage insurance will not be applied to the newly acquired loan.
Alternatives
Some lenders offer a second mortgage in place of mortgage insurance. If the second mortgage allows the loan-to-value ratio on the first mortgage to be below 80%, then mortgage insurance is not necessary. Here's how a loan might be structured:
$100,000
First Loan Amount
80%
$12,500
Second Loan Amount
10%
$12,500
Down Payment
10%
The example above shows an 80% first loan. As the lender in first position is only concerned that their loan does not exceed 80% (and in this case it does not), mortgage insurance would not be required.
The advantage of structuring a loan similar to the example above is all of the mortgage interest, that related to the first and second mortgage, is tax deductible. The disadvantage is the interest rate on the second mortgage may be too high for your liking. Have your mortgage professional calculate the numbers for a closer look.
Summary
Mortgage insurance plays a critical role in home ownership. Without it, many people would not be able to obtain a loan. Though somewhat expensive, it is a means of securing a mortgage and getting you moved in to a home. It doesn't remain with you forever, and there are financing alternatives which may eliminate the need for it.
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