How to Determine if Mortgage Insurance is Worth It – Which is Best for Your Home?
Buying a new home is exciting, but it can also be very stressful. Between all the fees associated with the purchase, new homeowners often feel like they are spending way more than they anticipated. Although some of these expenses are unavoidable, others, like mortgage insurance, require weighing the pros and cons.
So, should you add mortgage insurance cost to an already long list of financial demands, or wait to purchase your dream home until you can gather a larger down payment? We’ll help you determine what’s best.
What is Mortgage Insurance?
If you are financing your new home using a conventional mortgage, your lender will generally require that you make a down payment equivalent to 20 percent or more of the purchase price. If you are not in a position to pay that amount, never fear. It does not necessarily mean that lending institutions like banks, credit unions, or new home builders will turn you down. However, they will typically demand that you pay for private mortgage insurance (a.k.a. PMI).
If you apply for a government-backed loan, like FHA or USDA, you will automatically have to pay for mortgage insurance as well. These loans offer many advantages: lower closing costs, lower down payment, lower credit requirements, etc. However, you will need to take the mortgage insurance premium (a.k.a. MIP) into account in your calculations.
The purpose of mortgage insurance is to help alleviate the risk the creditor takes by lending you money. The lender would be the sole beneficiary of the policy if you were to default on your loan. The good news is that you do not need to pay mortgage insurance for the entire life of the loan.
With PMI (in the case of a conventional loan), it will automatically be canceled once your equity reaches about 22 percent based on the appraised value of the property. However, you can ask for the lending institution to cancel it as soon as your equity reaches 20 percent of the property's value.
With MIP (for a government-backed loan), you will need to pay at least 22 percent of the total value of the loan and pay your monthly payments for at least five years before canceling the mortgage insurance.
How to Calculate Mortgage Insurance Costs
To determine whether it is best for you to take on the mortgage insurance premium or to assume the down payment cost upfront instead, you will need to calculate the mortgage insurance cost.
The easiest way to determine it is to use a mortgage calculator. However, you can also calculate it by yourself. Keep a list of your mortgage loan documents nearby, since you will need to refer to them.
1. Start with the purchase price of the property and determine the loan-to-value ratio: the higher the rate (and therefore, the higher the risk for the lender to lend you money), the higher the mortgage insurance cost will be.
- LTV= loan amount / property value
2. Check the terms of your loan. They depend on your lending institution, your credit score, the type of loan, etc. They should also include the mortgage insurance rate: depending on your situation, it should account for 0.3 percent to 1.15 percent of the original loan amount per year.
3. Calculate the mortgage insurance amount:
- Annual mortgage insurance = Loan amount x insurance rate
- Monthly Payment = Annual mortgage insurance / 12
- Monthly house payment = Loan principal + loan interest + taxes + mortgage insurance monthly payment
Planning for the Future
Establishing whether the mortgage insurance cost is worth it is not an easy task. You will need to carefully evaluate your current financial situation and your plans for the future to determine the best course of action. Remember that purchasing a home and contracting a mortgage is a decision that could follow you for decades. There are several alternatives to paying for private mortgage insurance or mortgage insurance premiums.
- You can choose to wait to purchase a home until you have enough for a down payment equivalent to 20 percent or more of the purchase price. However, as you wait, you may be spending money on rent that could go toward building equity on your own property.
- You can negotiate with your lender to waive the mortgage insurance requirement and agree to pay a higher interest rate for the life of the loan. You will likely end up paying more in the long run, since mortgage insurance is only necessary until you own at least 20 percent of your home. However, unlike mortgage insurance costs, mortgage payments are tax-deductible.
- You may take a second mortgage (or piggyback mortgage) at the same time as you take your principal mortgage. It allows you to cover the difference between your current down payment and the 20 percent necessary to avoid paying for mortgage insurance.
Contributed to Your Home blog by Alix Barnaud
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