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Mortgage Insurance. Avoiding it. Eliminating it.
If the loan to value ratio of a mortgage loan is greater than 80% a borrower must qualify for and obtain a mortgage insurance policy. The amount of mortgage insurance coverage depends on the loan to value ratio. The higher the loan to value ratio, the more coverage that is required and the higher the premium. Borrowers with median credit scores below 760 will have higher insurance premiums. The lower the credit scores the higher the premiums.
But why? What is mortgage insurance anyway? Well … If a lender is forced to foreclose in the event of a default and the property is sold at a “fire sale” price and the proceeds of the sale are insufficient to cover the outstanding balance of principal and accrued interest and costs of foreclosure at the time of the sale, the lender will experience a loss. It will not recover the full amount of the debt.
Example: A loan on a $100,000 purchase is $95,000 (95% LTV ratio). The borrower defaults on the initial payment after losing their job immediately after closing and it takes the lender six months after default to foreclose. An additional $2,400 in accrued interest and $600 in expenses and legal fees for foreclose create an outstanding balance of $98,000 at the time of foreclosure. The property is sold at the foreclosure sale for $86,000. The lender will have a loss of $12,000.
If the borrower obtained mortgage insurance that policy will likely cover that loss. The insurance company will pay the lender all or a portion of the $12,000 loss. That’s what mortgage insurance covers. The potential loss due to inadequate equity in the event of a foreclosure.
Choosing the payment method
Mortgage Insurance on FHA Loans
On FHA loans a borrower can obtain a mortgage with as little as 3 ½ % down. And although FHA loans may have lower interest rates, a borrower will pay both a lump sum premium of 1.75% of the loan amount at closing and a renewal premium of either .80 or .85%, paid monthly. Thus the FHA loan has both an up-front premium and a hefty renewal premium. The insurance on an FHA loan, insured by the Department of Housing and Urban Development (HUD), is referred to as a mortgage insurance premium or “MIP”.
Mortgage Insurance on Conventional Loans
On Conventional loans (loans that are not insured by the federal government) a borrower can obtain a mortgage loan with as little as 3% down. On loans with a loan to value ratio greater than 80% (less than 20% down on purchases) the borrower will obtain private mortgage insurance (PMI) from a private insurance company (as opposed to insurance provided by the federal government on an FHA loan).
Single Premium Mortgage Insurance – The mortgage insurance can be paid in a variety of ways. On a transaction with either 3% or 5% down, a borrower with good to excellent credit scores can obtain PMI with a single up-front premium paid at closing with a premium ranging from 1.45% to 1.95%. The up-front premium can be paid at closing by the borrower (or the seller) or it can be financed by increasing the loan amount to cover all or a portion of the premium. The premium can even be paid by the lender with the charge being passed on to the borrower in the form of discount points.
Monthly Mortgage Insurance – Alternatively, the borrower can pay the PMI premiums monthly with nothing paid up-front.
Split Premiums – Finally, the borrower can elect to obtain “split” premium with both an up-front premium (that is slightly lower than what is paid for single premium PMI) and a monthly renewal premium (that is slightly lower than the straight monthly PMI premium).
The choice of which payment method is most beneficial for the borrower will depend on how quickly the borrower can eliminate the requirement for mortgage insurance by reducing the principal balance on the loan and on other factors such as the borrower’s credit scores.
Regardless of which method is chosen, for most borrowers with credit scores about 700, a conventional loan with private mortgage insurance will provide a lower payments and lower overall financing costs than an FHA loan with MIP. In a range from 620 to 699, the transaction should be evaluated on a case by case basis to determine whether FHA or conventional financing will provide a lower payment. Because qualifying with lower credit scores is easier going the FHA route, for borrowers with credit scores below 620, FHA may be the only viable option.
AmeriFund loan consultants are trained to assist applicants in choosing the most beneficial method of structuring the transaction and the payment of mortgage insurance premiums.Avoiding mortgage insurance
There is another alternative to the FHA MIP and the various conventional PMI options. The alternative is a dual loan “Piggyback” transaction which utilizes two separate loans, a first lien mortgage at an 80% LTV and a second “subordinate” mortgage in amount that takes the combines loan to value ratio up to as high as 97%. Because the first lien mortgage is at an 80% LTV the borrower does not have to obtain or pay for mortgage insurance. The rate on the second lien is at a much higher rate than the first lien but that higher rate is only being charged on a small portion of the overall financing.
In most cases the avoidance of the monthly PMI payment more than compensates for the higher rate on the second lien and for the slightly higher pricing on the first lien (due to a pricing adjustment for the secondary financing). In most cases, even though both the first and second lien interest rates are higher than on options with PMI, the avoidance of the monthly PMI nevertheless results in a lower overall payment.
For most borrowers either the Single Premium method or avoiding mortgage insurance with a “Piggyback” loan structure will provide the most beneficial financing method. An AmeriFund loan consultant can run an analysis to determine which method benefits the loan applicants based on the particular circumstances of that individual and that transaction.
Eliminating Mortgage Insurance
With recent changes in the law relating to FHA loans, the borrower will pay the monthly MIP renewal payment until the loan is paid in full. There is no longer a point at which the MIP is eliminated.
For private mortgage insurance that is paid monthly (and on “split” premium transactions) the requirement for maintaining private mortgage insurance is eliminated when the balance on the mortgage loan is reduced to a level that is 78% of the original price or value of the property at the time the loan was originated or 80% of the original price or value if the borrower affirmatively requests renewal and meets other criteria.
For this reason, if a borrower anticipates paying extra principal rapidly to reduce the balance to less than 80% of the purchase price or value at the time the loan was originated the monthly PMI structure will typically be the best choice. However, for a borrower that plans to pay principal rapidly, paying down on the second lien to eliminate that loan in a “Piggyback” structure will typically still make the “Piggyback” structure a better choice than the monthly PMI alternative.
Read more about the advantages of conventional loans and private mortgage insurance over FHA loans and FHA MIP in our Guide on FHA vs Conventional.