by Erik J. Martin
As if the costs involved with paying a mortgage loan weren’t enough in a challenging financial climate for home borrowers, there’s another expense you may need to reckon with, particularly if you’re upfront dollars are tight: mortgage insurance, which is typically charged by the lender if you make less than the expected down payment.
“Mortgage insurance protects lenders in the event a borrower defaults on their loan. If you cannot pay back the loan, mortgage insurance will cover the lender’s loss,” says Andrew Latham, a personal finance expert with SuperMoney in Santa Ana, California.
The minimum down payment requirements and the mortgage insurance amount your lender will charge will vary based on your loan type. For example, with conventional loans backed by Fannie Mae or Freddie Mac, you’ll have to pay private mortgage insurance (PMI) if you put down less than 20% of the home’s purchase price.
“Costs can vary, but PMI will typically range from 0.3% to 1.5% of your original loan amount every year. PMI can usually be canceled on a conventional loan once you reach 20% equity in your home, which occurs by paying down your principal owed every month combined with your home increasing in value over time,” explains Jeff Rose, a certified financial planner and founder of GoodFinancialCents.com. “To eliminate PMI properly, a formal appraisal may be required to verify your home’s value and your accrued equity.”
Note that the PMI may not drop off automatically at the 20% equity mark; you may have to reach out to your bank or lender and request that the PMI be canceled.
“Legally, your conventional loan lender must automatically terminate PMI when your loan-to-value amount reaches 78%, which equates to a 22% equity position,” says Dave Flanders, owner of HomeVisors Collective in Burlington, Connecticut.
Mortgage insurance can also apply to FHA loans. These loans require both an upfront mortgage insurance premium, paid one time at closing and equating to 1.75% of your loan amount, and an annual mortgage insurance premium (often 0.45% to 1.05% of your loan amount) that is paid monthly over the life of your loan if your down payment is less than 10%.
“If your FHA loan originated after June 3, 2013, and your down payment was less than 10%, you’re stuck with monthly mortgage insurance payments for the life of your loan. But if your down payment is at least 10%, your monthly mortgage insurance can be removed after 11 years,” Latham explains.
Or monthly mortgage insurance can be removed if you refinance your FHA loan to a conventional loan. Note, however, that you would still have to pay PMI on the new conventional loan if you haven’t earned 20% equity in the home—after which time the PMI can be canceled.
If you are an active-duty military member, veteran, or surviving spouse who has a VA home loan, the good news is that you are not required to pay for mortgage insurance.
“But you will be charged a one-time funding fee at closing, unless you qualify for a special exemption, that will vary based on factors like your down payment and military service,” Rose cautions. This funding fee can range from 1.25% to 3.3%, depending on your down payment and if this is your first home or not.
If, instead, you have a USDA loan, which applies to eligible homes in rural locations, you’ll have to fork over both an upfront guaranteed fee (often 1% of the loan amount) and an annual fee (usually 0.35% of your outstanding loan balance).
“Fortunately, your annual USDA loan fee can be canceled once your loan balance reaches 78% of your home’s appraised value or if you refinance your USDA loan to a conventional loan once you have built sufficient equity,” adds Rose. “But your upfront guaranteed fee is non-refundable.”
Remember that, while the thought of paying for mortgage insurance monthly, annually, or upfront is a downer, it’s considered a fair tradeoff if you can’t come up with a large enough down payment. After all, if you were required to come up with at least 20% on any home loan, many home buyers would be priced out of financing options entirely.
“If you are paying mortgage insurance, always keep a close eye and your home’s equity and review your numbers quarterly, especially in fast-appreciating markets,” Flanders suggests. “When you are close to the 20% equity mark, approach or lender about dropping PMI or consider refinancing if necessary.”