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Mortgage insurance, or sometimes known by its variation private mortgage insurance (PMI), is an insurance policy which pays the lender or investor for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private, with the federal government issuing public mortgage insurance, and several companies issuing private mortgage insurance. In the UK, it is known as mortgage indemnity guarantee.
The History of Mortgage Insurance
Mortgage insurance first started in the United States in the 1880s. However, the mortgage industry really started using it during the 1920s real estate bubble. And just like in the financial crisis of 2007, the Great Depression bankrupted the mortgage insurance industry because they used a practice known as “mortgage pools”, which was just like the mortgage securitization that led up to the financial crisis. After the massive bankruptcies, it wasn’t until 1956 when private mortgage insurance was once again legal to be sold.
Private Mortgage Insurance
Private mortgage insurance is typically required by lenders who aren’t going to be using public mortgage insurance offered by the United States government through Fannie Mae or Freddie Mac. There are also other types of loans, through the Department of Veterans Affairs (VA) or Federal Housing Administration (FHA), that offer public mortgage insurance.
This private mortgage insurance is typically asked for when there may not be enough equity in a property to cover the insurance company’s losses. That is why 20% is commonly used as a down payment. Depending on the risk to the lender, premiums typically range from 0.5% to 6% of the principal of the loan per year. Most premiums are paid monthly along with the mortgage payment.
The reason private mortgage insurance exists is so that individuals can purchase a home with a loan without having to put 20% down. The reason is that loans for more than 80% of the value are higher risk. However, once 20% in equity is reached – either through appreciation in home value or principal reduction via mortgage payments, a borrower may request the private mortgage insurance to be cancelled. To provide a margin of error, this amount is actually 78% of the value, not 80%.
However, when a private mortgage insurance policy is issued, the cancellation date must be specified based on when the loan is scheduled to reach 78% of the value, based on the original amortization table.
Finally, there is lender-paid private mortgage insurance available in some circumstances, although the “lender-paid” feature is a misnomer. This type of private mortgage insurance is usually a feature of low down payment loans that claim to not require PMI. The truth is, the cost of the insurance premium for the private mortgage insurance is just built into the interest rate charged on the loan. That explains why rates for these types of loans are usually 0.50% to 1% higher than a traditional loan.
Do You Need It?
So, the real question is do you need private mortgage insurance? And the answer is you don’t really have a choice unless you plan on putting a 20% or more down payment down on your home purchase. Private mortgage insurance will be decided by your lender and you will be required to select and insurance company or use the one your lender recommends.
However, you do have options to avoid it if you choose a different type of loan program. For example, you could go with an FHA loan if you qualify for it. With an FHA loan, you don’t pay private mortgage insurance, but rather, the loans carry a government guarantee and you pay a public mortgage insurance premium for that guarantee. The premium is typically paid in two parts – a premium paid upfront equal to about 1.75% of the loan amount, and then an annual premium of 0.5% paid with your monthly mortgage payments.
A similar program exists for eligible veterans and their spouses. A VA loan offers up to 103% financing on a home with no private mortgage insurance. Instead, you pay an upfront premium of up to 3.15% of the loan amount, which essentially is a lump sum public mortgage insurance premium payment.
These programs may help you avoid private mortgage insurance, but in the end, if you don’t put down 20%, you will pay a mortgage insurance premium somehow.
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