Understanding the Role of Mortgage Insurance in FHA Loans
What is Mortgage Insurance?
To protect themselves against financial risk, lenders use many tools, including insurance. Mortgage insurance is essentially an insurance policy that protects the lender from financial loss in the event of a default on the loan. If the loan is insured and the borrower is unable to make payments, the insurance provider will compensate the lender. In a way, you can think of mortgage insurance in the same regard as car or home insurance; if there is a financial loss, the owner is compensated by the insurance company.
But there is a bit of a twist with mortgage insurance. Instead of the lender paying the insurance premium, the borrower pays for the insurance coverage. Yes, it protects the lender, not the borrower, but in the end, it is the borrower who pays for the insurance. Sounds a bit like a bad deal for borrowers, doesn’t it? Not when you consider the advantages!
Quite frankly, if it wasn’t for mortgage insurance, some mortgage loans would not be available. Mortgage insurance reduces risk, and lenders only write loans when the risk is low enough. Factors like high credit scores, large down payments, and low debt-to-income ratios all work, statistically speaking, to lower the risk assumed by lenders. Another risk reducer is the handy mortgage insurance.
Mortgage insurance is sometimes called Private Mortgage Insurance (PMI), although the insurance attached to FHA loans is not PMI. Private insurance applies to conventional loans that are made by a private company and not backed by the FHA. For FHA loans, it is generally referred to as MIP, for Mortgage Insurance Premium.
Mortgage insurance is generally required for almost all loans until a certain percentage of equity is reached. (More on removing mortgage insurance below.) However, with FHA loans, mortgage insurance is required regardless of your down payment.
The mortgage insurance you pay on an FHA loan will fall into two categories:
The first is an upfront mortgage premium. This is usually 1.75% of the total loan amount, and it will be paid when you get your loan. If the loan is structured properly, you can roll the upfront amount into the loan balance, helping you avoid significant upfront costs.
You will also have to pay an annual mortgage insurance premium. This is roughly .45% to 1.05% of the loan amount, but it will change depending on the terms of the loan, such as whether the loan has 15-year or 30-year terms. This premium amount is compounded to the loan every year, then divided by 12 and paid monthly.
How Long Will Mortgage Insurance Last for an FHA Loan?
That depends on how much of a down payment you originally brought to the loan. If at the time you were able to put down 10%, the mortgage insurance will actually end after 11 years. Also, if the original loan was made before June of 2013, you will have the chance to cancel your mortgage insurance if the loan’s original terms meet certain standards for loan-to-value ratios.
However, in many cases the mortgage insurance on an FHA loan is permanent. Essentially, you will pay the insurance premiums until you have completely paid off the loan…but there is a way out.
How to Remove FHA Mortgage Insurance
For some FHA loans, mortgage insurance is permanent. If it was opened after June 2013, had less than 10% down, and was on a 30-year repayment schedule, then mortgage insurance will stay until the loan is repaid.
There is a way to remove mortgage insurance if you have an FHA loan, but it does not involve the FHA Streamline Refinancing. To remove mortgage insurance, one of the best strategies is to refinance into a conventional loan once you reach a certain equity level.
With most conventional loans, once you reach 20% equity (you own 20% of the property), the mortgage insurance is removed. This number can vary (usually between 18 or 22%), but it usually hovers around 20%. Refinancing into a conventional loan after you’ve improved your credit score is another way to might be able to remove mortgage insurance.