Conventional Mortgage Insurance Explained
For those who hear the term “mortgage insurance” for the first time and outside the process of buying a home or refinancing an existing one, they might automatically think that mortgage insurance is an insurance policy that makes the mortgage payments when the owners cannot.
For instance, a couple buys a home and needs both spouses’ income in order to qualify for the mortgage. After a couple of years, one spouse is laid off and the employer has closed its doors. Yes, there is unemployment insurance but it’s not enough to make the mortgage payment and still keep up with the other bills. A mortgage insurance policy kicks in and makes up the payment deficiency.
But that’s not mortgage insurance at all.
Conventional mortgage insurance, typically referred to as Private Mortgage Insurance, or PMI, is indeed an insurance policy but it is in the favor of the mortgage company, not the borrower.
Conventional mortgages are those that are not backed by a government program such as a VA or FHA loan. Instead, the lender takes the risk and there is no compensation to the lender should the mortgage go into default and be foreclosed upon. That’s why conventional mortgages used to require a higher down payment due to this additional risk and no loan guarantee. For instance, a loan underwritten to Fannie Mae guidelines would have a minimum down payment requirement of at least 20 percent of the sales price. That kept many out of the conventional mortgage marketplace and turn toward government-backed programs.
Conventional Mortgage Insurance : The Beginning
Yet in 1958 an insurance company came up with an insurance policy that would cover the difference between the 20 percent mark and the amount the borrowers used as a down payment. For example, if a home is sold for $200,000 then 80% of that is $160,000. The buyers would need to come up with $40,000 in addition to funds needed for closing costs.
A mortgage insurance policy could be purchased instead of coming up with the 20 percent down payment. The buyers could take out a mortgage insurance policy that would cover 10 percent of the sales price along with a down payment of 10 percent. The loan amount would then be $190,000, the down payment would be $20,000 and the insurance policy covering the remaining $20,000. Should the loan ever go into default, the lender would at least be compensated for the $20,000 covered by the premium. The lender would still be forced to foreclose and the home sold at a foreclosure auction.
If the buyers put down 5 percent of the sales price in this example, the loan amount would be $190,000, $10,000 from the buyers with a mortgage insurance policy covering $30,000, or 15 percent of the sales price. Again, it’s the lender that receives the compensation, not the owners.
How Mortgage Insurance Premiums Are Paid
Buyers can elect to take a borrower-paid policy annually that is paid in monthly installments. This is the most common method. The mortgage insurance premium is paid each month by the lender then held to pay for and renew the annual mortgage insurance premium.
Borrowers can also elect to make a single premium payment instead of an annual policy which renews. The policy may be rolled into the loan amount or paid for at the closing table out of pocket but most do in fact include it with the loan. Note in this instance the amount borrowed is higher and the monthly payments will be slightly affected. Such policies may also be refunded should the loan be retired early by a sale or refinancing into another mortgage program that does not require conventional mortgage insurance. There is another borrower paid single premium that is not refundable but slightly lower in cost.
There is also a “split” option where there is an upfront premium rolled into the loan amount along with an annual policy paid in monthly installments. The upfront premium may also be refundable or non-refundable.
Lenders can pay the mortgage insurance on behalf of the borrowers. With this approach, the mortgage company adjusts the interest rate slightly higher then provides enough credit to cover the PMI policy. The lender paid policy is not refundable and is a one-time charge with no monthly payments required.
Finally, as with other closing costs, the premium can be paid for by the sellers, all or in part.
How Conventional Premiums Are Calculated
Mortgage insurance for conventional loans are risk-based similar to how an interest rate for a client is calculated. There are adjustments to the conventional loan for occupancy. As with an interest rate, the best premium is for a loan used to finance an owner-occupied property then slightly higher for a second home and higher still for a rental property that will not be occupied by the borrowers.
Credit scores are also an important factor. Just as scores are used to assign an interest rate so too are credit scores used to calculate a mortgage insurance premium. Obviously, the higher the score, the better the rate.
How much down payment is present is also considered with higher rates assigned to transactions with a lower down payment. Borrowers with a 5.0% down payment will see slightly higher premiums compared to someone with 10 or 15% down. There are also differences with fixed rates, hybrids and adjustable rate loans.
Lenders can input the important facets of the loan into an automated system electronically and receive the various payment options for any specific borrower when running a specific scenario or submitting the loan application directly from the loan officer’s software program that processes mortgage loan applications.
Conventional mortgage insurance may also be tax deductible for those who itemize their federal income taxes just as mortgage interest is tax deductible, at least through the end of 2016 and for mortgages insurance taken after 2006. Congress has extended this deductibility multiple times and there is no reason to expect the deductibility to not be extended into 2017 as well.
It used to be that mortgage insurance got a bad rap. Yet the changes made to how the IRS treats conventional mortgage insurance as well as different payment options, the fact is that mortgage insurance is a good thing. Instead of coming up with a 20 percent down payment, buyers can obtain conventional financing using a conventional mortgage insurance policy.