Mortgage insurance / PMI is offered by either the government or private insurance companies to enable lenders to offer smaller downpayments on loans. Before mortgage insurance existed, many had to pay a minimum of 20% down to purchase a home which made homeownership unaffordable for many Americans. Mortgage insurance covers lenders for losses up to a certain amount if a borrower defaults on their mortgage.
Conventional or private mortgage insuranc eenables lenders to offer Conventional loans with a minimum down payment of 3% to 5%. Many 3% down loan programs are restricted to low or moderate income borrowers.
Example of downpayment costs:
—$400,000 home purchase with a 20% downpayment requires $80,000.
—$400,000 home purchase with a 5.0% downpayment requires $20,000.
—$400,000 home purchase with a 3.0% downpayment requires $12,000.
One can see a great benefit from being able to use mortgage insurance from a conservation of cash perspective.
The cost of mortgage insurance will vary greatly, depending upon several factors:
In addition, depending upon the alternative selected, the cost of mortgage insurance can be an upfront fee, an additional monthly payment, or financed into the loan amount or interest rate. Or the cost may be represented by some combination of these alternatives.
There are a wide variety of mortgage insurance alternatives. In this case, we compare two major alternatives. Conventional mortgage insurance paid monthly and conventional mortgage insurance in which the cost of insurance is paid through a higher interest rate.
These examples are for illustration only:
Monthly example: $300,000, mortgage insurance rate of .40%. The monthly payment would be $100.00 per month.
Higher interest rate example: $300,000 mortgage and 0.375% added to the interest rate: approximately $65.00 per month in additional payment monthly.
At first blush, opting for a higher interest rate in this case would be the best option. However, there are other factors involved:
In addition, if the loan is an FHA loan with a minimum downpayment, the mortgage insurance can never be cancelled.
This means that if the home was purchased below market value, significant improvements are to be made to the home, or if the owner is going to pre-pay the mortgage, one may have to pay the monthly mortgage insurance payment for as little as two years before cancelling it. When you roll the mortgage insurance cost into the interest rate, you would have to pay until the loan is paid off in the long-term, or the home is sold, or the loan is refinanced.
There are options to eliminate mortgage insurance altogether by getting a second mortgage on the property. Here is an example:
Like the choice of mortgage insurance options, there are advantages and disadvantages with both alternatives, besides the difference in payments. For example, while the mortgage payment is more likely to be tax-deductible under the first and second mortgage scenario, you must pay on a second mortgage until it is paid off or is refinanced, while the mortgage insurance may be cancellable in the future.
In addition, the second mortgage is likely to be at a higher interest rate as compared to the first mortgage and could either be amortized over 15-years which requires a higher payment, or an adjustable rate mortgage, whose rate may change in the future. Thus, the home purchaser must consider additional benefits and costs besides the difference in payments.
The decision of whether to pay mortgage insurance or not and what alternatives to choose is complex and will change based upon the situation, including the qualifications of the buyer and the nature of the transaction. That is why it is so important to obtain the advice of an expert mortgage advisor before you purchase a home.