Buying a house is the biggest financial investment most people make in their lifetime. To be as informed as possible, it’s important to understand exactly what you are paying for and how the costs are calculated. One of the most misunderstood and overlooked items included in your monthly mortgage payments is mortgage insurance.  

Mortgage insurance should not be confused with homeowner’s insurance. The line item added to your monthly payments every month and labeled insurance does not protect you from natural disasters, theft, or liability if someone gets hurt on your property. Homeowner’s insurance is a separate insurance policy you have to take out before you can close on the property you are buying.  

What is Mortgage Insurance?

Mortgage insurance protects the lender in the event you default on your loan. It also allows borrowers to buy homes with less than 20% down. This is a value for many people who don’t have enough money saved to make a substantial down payment.  

Mortgage insurance is an added cost for borrowers. Borrowers must pay an initial mortgage insurance premium equal to one and three-quarter percent of their loans. In addition to the up-front premium, there is a monthly mortgage insurance premium (MIP) that can vary anywhere from 0.45% to 1.05% of the loan.  

How Much Does Mortgage Insurance Cost?

The 2 different types of mortgage insurance associated with FHA loans are as follows:

Upfront Mortgage Insurance Premium (UFMIP)
This is a lump sum paid at the beginning that is equal to 1.75% of your mortgage loan amount. You can pay it in cash or request that the seller pay it, but most of the time the UFMIP is added to the loan amount. 

For example, if you borrow $200,000 at 3.75% interest, your UFMIP will be 200,000 x 1.75% or $3500. You add the $3500 to your $200,000 for a total loan amount of $203,500. The addition of the UFMIP to the original loan amount in this example will increase the monthly payment by about $15. 

If you switch to another FHA loan within seven years of the start of your mortgage, you can get a partial refund of the premium, but you’ll have to pay a new premium as a part of the refinance. 

Mortgage Insurance Premium (MIP)
The other type of insurance required by FHA is the MIP. This a yearly charge but you pay it monthly as part of your mortgage payment. The amount added to your monthly payments depends on the down payment you made. 

For example: Using the example above, your total loan amount (with the UFMIP added to it) is $203,500. If you made the minimum down payment of 3.5%, you would multiply the $203,500 by an MIP factor of 0.85% to get the annual charge of $1729.75. Divide the $1729.75 annual charge by 12 to get the monthly charge of $144.14. This amount is added to your monthly mortgage payment. 

Pros of FHA Mortgage Insurance

Lenders can accept lower down payments.The insurance you pay reduces the financial risk associated with default. This gives lenders more flexibility when it comes to approval guidelines. 

Qualifying for a home loan is easier.One of the reasons FHA loans are so popular is because first-time homebuyers without superior credit and low debt-to-income ratios can still qualify for them. If your credit rating is at least 580, you are eligible for a 3.5% down payment. The FHA allows a debt-to-income ratio of 43% (in some cases higher). 

Credit scores don’t change mortgage insurance rates.Your mortgage premium is going to be the same no matter what your credit score is. That means your monthly payments will be a lot lower than if you had gotten a comparable conventional loan. 

Cons of FHA Mortgage Insurance

It increases monthly payments. FHA's insurance is higher than that required by any other kind of low down payment loan. Over 30 years, the amount of insurance you pay adds up to a significant amount. 

It’s with you for the life of your loan.As long as you are paying on your mortgage, you will have mortgage insurance added every month if you made a minimum down payment. It doesn’t matter how much equity you build up. That makes is very expensive when you compare it with conventional loans that don’t require any mortgage insurance if you make a 20% down payment. 

Can I Avoid Mortgage Insurance?

There are only three ways to eliminate mortgage insurance on an FHA loan. 

1. Pay off your loan in full.If you pay off your mortgage, you own the house free and clear. This eliminates mortgage insurance and your monthly mortgage payments. 

2. Switch to a conventional mortgage.If you have 20% equity in your house or have the means to pay down your mortgage to 80%, you can switch to a conventional mortgage and eliminate mortgage insurance. There are credit score and interest rate issues associated with conventional mortgages that can impact whether or not it makes economic sense to refinance. You should do a cost comparison before you pay for an appraisal and refinance. 

3. Make a 10% down payment and pay the mortgage insurance for 11 years.This option won’t eliminate mortgage insurance immediately, but if you have the resources to make a 10% down payment, the FHA will cancel the premiums after 11 years. 

Eliminating MIP on Loans Made Before June 3, 2013.One of the advantages of conventional loans is that mortgage insurance is automatically eliminated once your loan is 78% of the value it had when your house was purchased. Until June 3, 2013, the same applied to FHA loans. 

Unfortunately, the FHA changed the guidelines for loans made after June 3, 2013. Here are the new guidelines for getting rid of your FHA mortgage insurance based on your down payment and the terms of your loan. 

20 - 30-year loan with less than 10% down payment = 78% loan to value with a 5-year minimum 
20 - 30 year loan with 10% - 22% down payment = 78% loan to value with a 5 year minimum
20 - 30-year loan with more than 22% down payment = 5 years 
15-year loan with less than 10% down payment = 78% loan to value 
15 year loan with 10% - 22% down payment = 78% loan to value 
15-year loan with more than 22% down payment = no MIP required 

What’s the Difference Between FHA's Mortgage Insurance and Conventional Loan Mortgage Insurance?

There are three major differences between FHA and conventional loan mortgage insurance. 

1. You only pay mortgage insurance on a conventional loan if you make less than a 20% down payment. 
2. You only need one kind of mortgage insurance with a conventional loan. With an FHA loan, you need two, upfront and annual. 
3. Conventional loan mortgage insurance is influenced by how much money you put down and your credit score. It can also be influenced by where the purchased property is located and how many people are on the loan. 

If your credit rating is less than 680, you should consider going with the FHA to finance your home purchase. You won’t pay more mortgage insurance because you have a lower score, and you have the option of switching to a conventional loan if your credit rating improves.