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What's the Deal With Mortgage Insurance? Peter G. Miller - Mortgage Lenders Plus.com Add to Delicious, diggit, reddit, technorati favs

According to the National Association of Realtors the typical existing home sold for $230,100 in June. Imagine if the only way to buy such a property was to purchase with 20 percent down plus closing costs. While settlement expenses vary by state, 20 percent down would be equal to $46,020 in cash -- a sum not found in most checking accounts.

NAR also says something else: According to its 2006 Profile of Buyers and Sellers, the typical first-time buyer purchased a home with just 2 percent down while repeat buyers put up just 16 percent.

For many buyers the ability to purchase with little down is the key to home ownership. If everyone actually had to come up with 20 percent down home sales would fall through the floor and ownership would have to be postponed for years.

So how does it happen that buyers are able to purchase with so little down?

A "conventional" mortgage is generally defined as financing equal to 80 percent of a home's purchase price -- in other words, a loan where the 20 percent balance is either cash put up by the buyer, another loan or a combination of the two. But another way to buy is with less down and to substitute insurance for cash or a second loan.

Instead of needing $46,020 for that typical house, a purchase could be made with zero down under the VA plan, 3 percent down with FHA financing and 5 percent up-front with private mortgage insurance (MI).

There are charges to use mortgage insurance, but those charges should be seen in context.

First, most insurance premiums for mortgages loans taken out after January 1, 2007 are tax deductible. Check with a tax professional to see if this deduction will be continued after 2007 and -- as always -- look for exceptions and limitations.

Second, if you did not pay for mortgage insurance you would have to put up more cash. Your cash down payment would earn no interest. Depending on the interest you might receive for your cash and the cost of mortgage insurance, mortgage insurance may produce a better financial result than a big down payment. In other words, if you pay $1,000 a year in MI premiums but the cash not used for a deposit earns $1,500, you're ahead with mortgage insurance.

Third, the cost of mortgage insurance varies according to such factors as how much you put down and whether the loan is fixed or adjustable. Speak with lenders about mortgage insurance choices and options.

Fourth, using two mortgages to buy a home -- so-called "piggy-back" financing -- has become increasingly unattractive to lenders given today's growing foreclosure rates.

How does mortgage insurance work? Here are the four typical approaches:

FHA Insurance

The FHA mortgage program allows individuals to buy with as little as 3 percent down. The program has liberal qualification standards, but does require that all loans must be fully documented.

The cost of FHA insurance is divided into two parts: First, there is a 1.5 percent mortgage insurance premium up front, then there is a monthly premium which has an annual cost equal to .5 percent of the outstanding loan balance. For instance, with a $200,000 loan the up-front fee would be $3,000 -- an amount which can be added to the loan balance. The monthly cost would be roughly $83.33 in month #1 ($200,000 x .5 percent = $1,000. $1,000/12 = $83.33)

If you bought your home after January 1, 2001, then HUD says "for mortgages with terms more than 15 years, the annual mortgage insurance premiums will be canceled when the loan-to-value ratio reaches 78 percent, provided the mortgagor has paid the annual mortgage insurance premiums for at least five years."

In addition, the "FHA will determine when a borrower has reached the 78% loan to value ratio based on the lower of the sales price or appraised value at origination. New appraised values will not be considered. For example, if the lower of the sales price or the appraised value at origination was $100,000, when the loan amount reaches $78,000, FHA will no longer collect annual mortgage insurance premiums on the loan. Cancellation of the annual mortgage insurance premiums will normally be based on the scheduled amortization of the loan."

VA Insurance

Traditionally the VA mortgage program was designed as a benefit for those who had completed certain forms of federal service. The VA was originally a guarantee program available to veterans without charge, however today the program has been changed into an insurance program -- although a very inexpensive one. In basic terms, there's an up-front 2.15% funding fee for a vet who buys with less than 5 percent down.

The funding fee is reduced for qualified individuals who have a down payment of more than 5 percent -- but it is higher for reservists and national guard personnel as well as for those who use the program more than once. There is no monthly fee under the VA program, therefore there is no insurance coverage to cancel after the loan is originated. For specifics about funding fees, speak with a qualified lender or a base housing officer.

Private Mortgage Insurance

While the FHA and VA plans are federal programs, there is also private mortgage insurance (MI) -- insurance which is simply provided by private companies.

Both the VA and FHA programs have limitations. For instance, the VA program is restricted to individuals with certain federal service while FHA funding cannot exceed 87 percent of the conventional loan limit -- though at this writing there's an effort underway to increase the FHA loan limit.

What this means is that MI is available to all borrowers and that you can get coverage for larger loans than those available under the FHA program.

The cost for MI coverage varies, but a rough measure might be a fee equal to .5 percent of the outstanding loan balance per year. However, costs can be higher or lower depending on the amount down, the type of loan (fixed or adjustable) and other factors. Typically with MI there is no up-front fee, though there can be with some programs.

Like FHA coverage, MI can be canceled. According to the Mortgage Insurance Companies of America (MICA), the industry trade group, "under federal law, PrivateMI on most loans originated on or after July 29, 1999, will terminate automatically once the mortgage has amortized to 78 percent of the original value of the house. The borrower must be current on all mortgage payments. The lender must tell the borrower at closing when the mortgage will hit that 78 percent mark. Nine out of ten borrowers cancel their PrivateMI within 60 months." The group has an online cancellation calculator at its web site, PrivateMI.com

Lender Self-Insurance

During the past few years an alternative to mortgage insurance plans has evolved, lender self-insurance. In this instance there is no FHA, VA or MI coverage. Instead the lender raises the interest rate and the additional dollars are used to fund an insurance pool to cover any lender losses.

Borrowers offered self-insurance ("no private mortgage insurance") should ask how much rates are being raised under such programs. Also, be aware that while FHA and MI coverage can be canceled once mortgage balances decline, interest rates remain for the life of the loan.