Understanding Mortgage Insurance (PMI, MIP) Requirements for Homebuyers and Homeowners
The two most common types of mortgage insurance coverage is private mortgage insurance (PMI) and FHA mortgage insurance.
In fact, FHA does not really lend money, as much as it insures FHA loans — through the use of FHA mortgage insurance.
Mortgage insurance protects the lender against losses that may arise from a mortgage loan default and foreclosure. It doesn’t cover all of a mortgage lender’s losses. But mortgage insurance does provide enough security for mortgage loan providers that their risk exposure is substantially lowered.
Private mortgage insurance (PMI) is normally required for all conventional loans in which you have less than 20% down payment. Moreover, the lower the down payment, the higher the premiums for PMI.
Although many borrowers may find it unfair that they are paying premiums on insurance that protects their mortgage lender, the truth is, in fact, more beneficial for the borrower.
Without mortgage insurance, most homebuyers would have to make down payments of at least 25% to 50% for standard loans. In fact, that was the norm before the Great Depression and the introduction of affordable FHA loans and FHA mortgage insurance. Mortgage insurance makes home buying and homeownership more affordable.
Insurance is all about risk exposure. Specifically, mortgage insurance limits the lender’s risk exposure.
Statistics and common sense clearly demonstrate that the less money homebuyers have invested in a property, the higher the risk (relatively) that they will default on their loan. Home buyers with 20% down payment invested in their property are less likely to go into default than homebuyers with only 5% or 3% down payment. At the very least, the more that a borrower has invested in a property, the harder that borrower will work to save that investment.
If a mortgage borrower defaults on the loan and the lender forecloses on the property, mortgage insurance protects the lender against inevitable losses.
For example, consider the scenario of Bob whose $100,000 home is foreclosed. Bob bought it last year with a $90,000 mortgage. Because he had not paid a mortgage payment during the nine months of his default and foreclosure period, Bob’s balance with the lender is actually about $105,000.
The lender eventually forecloses and orders an auction for the property at a price of $90,000. After all the legal, real estate services, administrative fees, the lender nets $75,000 from the sale. With total balance due of $105,000 and net revenue of $75,000, the lender has lost $30,000.
In this situation, the PMI company will reimburse all or most of the lender’s losses, depending on the type of insurance coverage. With FHA loans, the FHA usually exercises its option of buying the property from the lender and attempting to resell the property itself.
