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Mortgage insurance: What is it, why you need it, and how much it costs

Mortgage insurance: No one tells you about the benefits

PMI (private mortgage insurance) is usually required if you put less than 20 percent down on a house. It protects your mortgage lender in case you default on the loan. 

Many homebuyers try to avoid PMI at all costs. Why? Because mortgage insurance protects the lender, not you. But you still have to pay for it. 

But there’s another way to look at it. 

Mortgage insurance with less than 20% down can put you into a house sooner. 

You might pay a couple hundred dollars per month for PMI. But you could start earning upwards of $20,000 per year in equity.

So for many people, PMI is worth it. Mortgage insurance can be your ticket out of renting and into equity wealth.

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What is mortgage insurance? 

PMI — private mortgage insurance — is a type of insurance policy that protects mortgage lenders in case borrowers default on their loans. Here’s how it  works:

If a borrower defaults on their home loan, it’s assumed the lender will lose about 20 percent of the home’s sales price. 

20 percent — sound familiar? 

That’s the smallest down payment you can make without having to pay mortgage insurance. If you put down 20 percent, that makes up for the lender’s potential loss if your loan defaults. 

But if you put down less than 20 percent, the lender will usually require mortgage insurance.

Mortgage insurance covers that extra loss margin for the lender. If you ever default on your loan, it’s the lender that will receive a mortgage insurance check to cover its losses. 

That might sound like a tough deal. But the upside is, mortgage insurance gives you a fast track to home ownership. 

Without mortgage insurance, many people would have to wait years to save up for a bigger down payment before buying a house. 

Those are years they could have spent investing in their home and building equity — rather than paying rent to a landlord each month.

Find a low-down-payment mortgage today (Feb 15th, 2020)

How much is mortgage insurance? 

Mortgage insurance costs vary by loan program (see the table below). But in general, mortgage insurance is about 0.5-1.5% of the loan amount per year. So for a $250,000 loan, mortgage insurance would cost around $1,250-$3,750 annually — or $100-315 per month.

Mortgage insurance rates

Note that we cited “annual” mortgage insurance cost above. That’s because, for most loan types, there are two mortgage insurance rates: an annual rate and an initial rate or “fee.” The initial mortgage insurance fee is usually higher, but it’s only paid once when the loan closes. And both types of mortgage insurance vary by loan program: 

  Conventional Loans FHA Loans USDA Loans VA Loans
Initial Mortgage Insurance n/a “Upfront Mortgage Insurance Premium” “Upfront Guarantee Fee” “Funding Fee”
Rate* n/a 1.75% 1.0% 2.3%**
Annual Mortgage Insurance “PMI Annual Premium” “Mortgage Insurance Premium” “Annual Fee” n/a
Rate* 0.19-1.86% 0.85% 0.35% n/a

*Mortgage insurance rates are shown as a percentage of the loan amount

**VA funding fee is 2.3% for first-time use, and 3.6% for subsequent uses

Cost of mortgage insurance by loan type 

Each loan type has a different mortgage insurance rate. So even for the exact same loan size, mortgage insurance costs could be very different depending on whether you got a conventional mortgage, FHA, VA, or USDA mortgage. 

For example, say you buy a $300,000 home with 3.5 percent down*. Here’s how mortgage insurance costs would compare for the four major loan types: 

  Conventional Loan FHA Loan USDA Loan VA Loan
Initial Mortgage Insurance Cost $0 $5,000 $2,900 $6,700
Annual Mortgage Insurance Cost (Paid Monthly) $3,500 $2,500 $1,000 $0
Monthly Payment $280 $200 $84 $0

The above example assumes a $300,000 home purchase with 3.5% down, and a 30-year fixed interest rate of 3.75%. Your own rate and mortgage insurance costs will vary

*Annual mortgage insurance cost is calculated based on year 1 loan balance. Annual costs will go down each year as the loan balance is reduced

Mortgage calculator with insurance and taxes

How is mortgage insurance calculated? 

Mortgage insurance is always calculated as a percentage of the loan amount. For example: If your loan is $200,000, and your annual mortgage insurance is 1.0%, you’d pay $2,000 for mortgage insurance that year.

Since annual mortgage insurance is re-calculated each year, your PMI cost will go down every year as you pay off the loan. 

For FHA, VA, and USDA loans, the mortgage insurance rate is pre-set. It’s the same for every customer (see the table above).

For conventional loans, mortgage insurance is calculated based on the customer’s application. Conventional PMI mortgage insurance is calculated based on your down payment amount and credit score. 

>> Related: Guide to mortgage loan types

Calculating mortgage insurance by credit score

The following chart compares cost differences between the three major types of mortgage insurance, based on a $250,000 loan amount, and varying credit levels.

  660 FICO Score 700 FICO Score 740 FICO Score
Conventional 5% Down $295 $180 $120
Conventional 10% Down $210 $125 $85
FHA 3.5% Down $175 $175 $175
USDA 0% Down $75 $75 $75

Cost versus benefit of private mortgage insurance 

Today’s homeowners are building wealth like few times in history.

According to the Federal Housing Finance Agency (FHFA), home values are up more than five percent from one year ago.

The typical U.S. homeowner is earning $13,000 per year.

What’s more, home value appreciation is nothing new. FHFA says home prices have increased by about 5% per year since 2012.

Verify your mortgage eligibility (Feb 15th, 2020)

That means the renter who bought the average home four years ago has “made” more than $40,000 to date. Some have earned much more — six figures in some cases.

What’s surprising, then, is “advice” saying you should buy a home only when you have a 20% downpayment.

Putting 20% down is riskier than making a small down payment, but it’s also costly.

Even strong opponents of mortgage insurance find it hard to argue against this fact: PMI, on average, yields 530% return on investment.

PMI Comparison Of Equity Position

Homeownership is the primary means of wealth building in the U.S.

Owning a home is no path to quick riches. Rather, it’s an investment that pays off over time, even considering cyclical downturns.

Long-term housing data supports this fact.

According to the government lending agency FHFA, home values are up more than 140% since 1991. That means a home worth $100,000 in January 1991 is worth $240,000 today.

Over that time, inflation has risen 75%, says the Bureau of Labor Statistics. A first-time home buyer in 1991 has beat inflation, plus made an additional sixty-five percent return on investment.

Inflation-adjusted return is a tangible way to look at wealth increases, but there are non-tangibles, too.

For instance, a homeowner who purchased a home in 1991 is likely near the end of its 30-year fixed mortgage. Soon, the homeowner will be mortgage-free. Cost of living will drop.

The owner holds a considerable asset, too.

Yet, a person who chose to rent in 1991, and continued to do so, now pays ever-increasing rental prices.

Worse, it’s likely this person has no sizeable asset unless he or she has contributed to a retirement account or other investment consistently over two or three decades. Many have not been this forward-thinking.

A house is a forced savings account. Housing expenses are required whether you rent or own. But when you own, you deposit a small chunk toward your future wealth.

So what does PMI have to do with this? It starts the wealth-building process sooner. You can be on the winning side of rising home values.

And, without PMI, you may be unable to save fast enough to catch up with home prices.

Securing a home at today’s prices is a solid advantage. But there’s another one: PMI is an investment with a return like few others.

Verify your home buying eligibility with or without PMI (Feb 15th, 2020)

PMI return on investment

Home buyers avoid PMI because they feel it’s a waste of money.

In fact, some forego buying a home because they don’t want to pay it.

That could be a mistake. Data from the housing market indicates that PMI yields a surprising return on investment.

According to FHFA’s House Price Index, home prices are up 3.5% per year since 1991.

Home price acceleration has been higher of late — well past 5%. However, taking a longer view provides a more balanced, realistic view of the housing market — and what you might “earn” per year as a homeowner over the long run.

Keep in mind that the three-and-a-half percent gain factors in the housing downturn of the last decade. That percentage is not derived by looking only at a “rosy” period of market history.

The average home costs $233,000, per National Association of REALTORS® data. The following is an example of a buyer who purchases the “average” home with and without PMI.

First, assume the buyer puts 5% down.

The PMI cost is $135 per month according to mortgage insurance provider MGIC. But it’s not permanent. It drops off after five years due to increasing home value and decreasing loan principal.

You can cancel mortgage insurance on a conventional loan when you reach 78% loan-to-value.

The homeowner’s snapshot at the end of year 5 looks like this:

  • Current value: $276,000
  • Principal remaining: $200,000

In five years, the home has appreciated $43,000, and the final PMI cost is $8,100. That’s a 5-year return on investment of 530%.

It’s near impossible to make that kind of return in the stock market, retirement account, or another financial instrument.

PMI, then, can be viewed as an investment — a very sound one — and not a waste of money.

But that may not be where PMI’s benefits end. There is another factor when postponing a home purchase to avoid PMI: opportunity cost.

What it costs to avoid PMI

Assume a different homebuyer followed “best practices” as posited by many financial and housing advisors today.

The buyer chose to avoid PMI. Instead, he or she opts for a 20% downpayment: fifteen percent more than the buyer who chose PMI.

The buyer has some saving to do.

He or she budgets and plans to accumulate $10,000 per year toward the goal — difficult but doable. In three and a half years, the buyer raises the full 20% downpayment.

But not quite.

He or she is now chasing higher home prices. In 3.5 years, home prices will have risen nearly thirteen percent — factoring in compound interest — or around $30,000.

The buyer no longer needs 20% down based on home prices of three years ago. He or she needs twenty percent of the current home price.

That’s an additional six thousand dollars.

The increase pushes out the buyer’s time frame. He or she must save four years to put twenty percent down. During that time, the home buyer forfeits $34,000 in lost home equity.

Add up lost equity and extra downpayment costs, and waiting to buy has cost this buyer thirty-two thousand dollars — even after considering the PMI expense he or she “avoided”.

There are many good reasons to delay buying a house. Skipping PMI is not one of them.

Verify your eligibility to buy a home (Feb 15th, 2020)

PMI with direct-to-buyer benefits

PMI benefits the buyer indirectly, but some mortgage insurance companies now offer buyers direct value, too.

One PMI provider, Radian, layers its MortgageAssureSM product on top of its standard PMI coverage. This program offers job loss protection for the buyer.

The insurance covers the borrower’s payments — up to $1,500 per month for six months — in the case of a job loss during the first two years of the loan.

The program comes at no additional cost for home buyers who make a down payment between 3-5% on some loan programs.

This is peace of mind for the homebuyer and a very good reason to check which PMI providers your lender works with.

Mortgage lenders often work with three to five PMI providers. Most often, the lender will choose your provider for you. The choice is often arbitrary or based on who the lender is accustomed to using.

But the borrower can have a say in the matter. If you know of a PMI provider that offers a certain benefit, don’t be afraid to ask for it.

The small request could end up making a big difference later on.

How do I know if PMI is right for me?

Private mortgage insurance isn’t for everyone, but home buyers should check potential returns before they automatically refuse it.

Get a home buyer eligibility check, which includes a mortgage insurance analysis for your situation, and comes with no obligation. It takes just minutes to start.

Verify your mortgage eligibility (Feb 15th, 2020)

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