Mortgage insurance: how it works, coverage and cost

How does mortgage insurance work?

Private mortgage insurance (PMI) policies protect lenders from losing money through foreclosures and defaults. Policies are issued to banks and other financial institutions in the United States. In most cases, lenders require it when financing a client who is considered somewhat “risky.”

PMI is calculated based on your interest rate, loan-to-value (LTV) ratio, loan term, credit score and other risk factors. This amount is added to the overall expenses that make up your mortgage payments, or PITI (principal, interest, taxes and insurance).

Payments are due in monthly installments, usually until the borrower has gained 20% or more equity. PMI could also fall off once the balance of your loan hits 78% LTV based on the original appraisal or if the borrower is halfway through the life of their loan.

Lenders recalculate premiums annually, so you might see your costs go down each year as you continue to pay off the loan.

» MORE: How to get rid of PMI

PMI vs. MIP

PMI and mortgage insurance premiums (MIP) are two types of mortgage insurance that homeowners may be required to pay, but they apply to different types of loans and have different rules.

PMI for conventional mortgages

PMI applies to conventional loans — meaning those backed by private entities and not the government. PMI is typically required when a homeowner puts down less than 20% of the home's purchase price. The cost of PMI can vary but is usually between 0.5% and 1% of the loan amount annually.

“Most consumers are not aware that when your equity builds, you can remove your mortgage insurance without refinancing your home,” said Michelle Taylor, a loan originator with the lender Gold Financial Services. “You can call your current lender to get instructions on how to remove the mortgage insurance."

Borrower-paid mortgage insurance (BPMI) and lender-paid mortgage insurance (LPMI) are two different ways of paying for PMI.

• BPMI is a traditional method where the borrower pays the monthly premium until they can cancel PMI.
• For LPMI, the lender pays the PMI premium upfront, but this cost is typically passed onto the borrower through a slightly higher interest rate on the mortgage, and it cannot be canceled.

» COMPARE: Best mortgage lenders

MIP for FHA loans

MIP is required on all FHA loans, regardless of the down payment amount. The cost of MIP can vary based on the loan amount and term, but it typically includes an upfront premium of 1.75%, plus an annual premium ranging from 0.45% to 1.05%. Unlike PMI, MIP cannot be removed from an FHA loan unless you refinance into a conventional loan.

While MIP is an ongoing annual charge, you will also pay an upfront mortgage insurance premium (UMIP), a one-time charge that you pay at closing.

» COMPARE: Best FHA loan lenders

Fees for USDA and VA loans

If you are wondering if USDA or VA loans require mortgage insurance, the answer is: sort of. Both loan types charge fees that act similarly to mortgage insurance.

USDA guarantee fee

USDA loans, while not requiring traditional PMI, do have an upfront guarantee fee and an annual fee. The upfront guarantee fee is equal to 1% of the loan amount, and the annual fee is 0.35% of the loan balance.

» COMPARE: Best USDA lenders

VA funding fee

VA loans require a funding fee, which can range from 1.4% to 3.6% of the loan amount, depending on factors like the borrower's military service details, down payment and whether it's the borrower's first time using a VA loan.

Not everyone has to pay this fee. Some veterans and spouses are exempt, such as those receiving VA compensation for a service-connected disability.

» COMPARE: Best VA loan lenders

What does mortgage insurance cover?

Mortgage insurance protects the lender, not the borrower. Borrowers need to be aware that it’s not the other way around. For example, it does not cover the borrower if their house is destroyed by a disaster — that’s what homeowners insurance is for.

It is crucial to have a homeowners insurance policy in place before you close on your home. Remember, even though you might be required to pay mortgage insurance, it does not benefit you, and you should remove it when possible to save money.

» MORE: What is title insurance?

How to calculate mortgage insurance

You can get a rough idea of how much your mortgage insurance would cost with the following calculations. Keep in mind that some loan types might have upfront mortgage fees to consider, too.

• Determine your mortgage insurance rate: The cost of mortgage insurance depends on your LTV and credit score. With a lower LTV and higher score, you can expect a lower mortgage insurance rate. Your lender should be able to give you an exact number.
• Calculate your annual mortgage insurance cost: Multiply your loan amount by your mortgage insurance rate to find your annual mortgage insurance cost. If your loan is for $400,000 and your mortgage insurance rate is 0.5%, your annual cost would be $2,000.
• Calculate your monthly mortgage insurance cost: To find out how much mortgage insurance will cost you per month, simply divide your annual cost by 12. In this case, $2,000 divided by 12 gives a monthly cost of about $167.

Bottom line

Mortgage insurance lowers risk to lenders, which encourages them to approve borrowers who might not otherwise qualify. Its requirements vary by loan type, but you can generally expect to pay this insurance if your down payment is less than 20% of the home's purchase price for a conventional loan.

While paying mortgage insurance is not ideal, you can cancel your PMI or refinance your loan type later.