Mortgage insurance gets a pretty bad rap, and that may or may not be justified. Dropping your mortgage insurance can be a great way to reduce your monthly payments, as long as you have considered all of your options.

What is Mortgage Insurance?

First of all, mortgage insurance is NOT homeowner’s (hazard) insurance. Homeowner’s insurance protects your home in the case of a fire or some other accident/disaster. It allows your home to be repaired/rebuilt in the instances of those accidents. You can’t not have homeowner’s insurance if you have a mortgage (lenders require it), and even if you don’t have a mortgage, it’s still a good idea to protect your home with such insurance.

Mortgage insurance protects the lender (not you or your home) against losses they may incur if you default/foreclose on your home. Here is an extremely simplified example:

Let’s say I stop paying my $200,000 mortgage and 8 months later, the lender forecloses on my home. They sell the home at auction for $190,000, losing $10,000. They also have to pay attorney fees, collect back interest, etc. which adds another $5000 in costs. So, the lender lost $15,000. If I had mortgage insurance, the lender would be reimbursed (from the insurance company) for at least a portion of that money they lost.

What is the point of getting mortgage insurance?

You may be asking why you want to pay for an insurance policy that seemingly provides you with no benefit or protection. The majority of the time, mortgage insurance is required when you put down less than 20% when buying a home, or having less than 20% equity in your home (a loan-to-value ratio of more than 80%) when refinancing. Since there is less equity in the home, there is more of chance that the lender could lose money if you foreclosed, so that insurance allows them to assume the risk of giving you a mortgage, even though you didn’t put down 20%. Most home buyers don’t have 20% to put down when buying a home, so most first-time home purchases have some type of mortgage insurance.

How much is mortgage insurance?

The cost of mortgage insurance, expressed as a percentage of the loan amount, depends on several factors:

FHA Loans – New 30-yr FHA loans all carry mortgage insurance of 0.85% per year. If you had a $200,000 mortgage, the monthly premium would be $141 ([$200,000 * 0.0085]/12). A 15-yr loan would be less (about 0.5%). This rate is the same regardless of your credit score, down payment, etc. FHA loans before January of this year (2015) had a higher rate (or perhaps lower, depending on when the loan was originated.
Conventional Loans – The cost of mortgage insurance for conventional loans depends mostly on the amount of the down payment and your credit score, with other factors (such as the purpose of the loan) having a minor effect. The more you put down and/or the better your credit score, the lower your mortgage insurance premium will be. For example, someone with a 760 credit score and a 10% down payment would pay 0.39% per year ($65/month for a $200,000 mortgage), while someone with a 660 credit score and a 5% down payment would pay 1.15% per year ($191/month for a $200,000 mortgage).

How does one get rid of mortgage insurance?

Mortgage insurance may or may not be permanent:

FHA Loans – FHA loans originated after January of 2015 have permanent mortgage insurance.
Conventional Loans – When you have 20%+ equity in your home (a loan-to-value ratio of 80% or less), then your mortgage insurance can be dropped. So, as your home value increases and your mortgage balance declines, you will be closer to that point.

I heard of someone who got a loan for less than 20% down and isn’t paying mortgage insurance…

This happens sometimes and there are usually 3 possibilities as to how this can occur:

It’s a VA Loan – VA loans require no down payment and have no mortgage insurance. They’re beautiful.
They have a Lender-Paid Mortgage insurance policy – Mortgage insurance can actually be paid as a 1-time lump sum, called a lender-paid policy. This ranges anywhere from under 1% of the loan amount to almost 7% and again depends on credit and equity. Oftentimes with a home purchase, where the seller is paying the closing costs, the buyer can use those funds to by a lender-paid policy. The result is that they put down less than 20% and don’t pay monthly mortgage insurance (because it was paid as a 1-time fee and was part of the closing costs).
They really do have mortgage insurance – Oftentimes, the borrower doesn’t realize they’re paying it.

So, is it good or bad?

The easiest way to look at mortgage insurance is to see it as an increase in the interest rate. An FHA loan may have a 3.375% interest rate, but adding the mortgage insurance (0.85%) takes the effective interest rate to 4.225%. Whether that is good or bad all depends on what you are getting in return for paying that mortgage insurance and what your other options may be.

If you can avoid mortgage insurance with a higher down payment (or a cheap lender-paid policy) go for it, but here are some instances where it’s not bad to have it, or where you can’t avoid it:

You have less than 10% to put down and/or your credit isn’t perfect: If this is the case, a Lender-paid policy would be quite expensive. An FHA loan will likely be your best bet (which carries mortgage insurance).
You’re getting a really good deal on the home: If you’re pretty certain that you will have 20%+ equity in the home in a short amount of time, a conventional loan will not have mortgage insurance for long. It is an expense that will likely go away quickly.
You’re consolidating debt with an FHA refinance: An FHA loan will have mortgage insurance, giving you an effective rate of 4.225% (as of today’s rates), but if you’re paying off credit cards with interest rates of 15%, this makes sense. FHA loans also let you borrow 85% of the value of your home in a cash-out refinance (instead of just 80% with a conventional loan).

Considering dropping your FHA mortgage insurance?

If you have an FHA loan and your insurance is permanent, it might be wise to consider dropping it by refinancing to a conventional loan. Just consider the following:

Do you have enough equity? – Remember that you’ll need 20% equity to not have mortgage insurance at all (or at least 10% with good credit to get a lender-paid policy).
What will you’re new rate be? – There is a good chance a conventional loan may actually have a higher rate. You just need to compare the new rate to your effective interest rate, as well as the payments, to see if it makes sense.
What are the costs? – If a refinance saves you $100/month by dropping your mortgage insurance, but adds $5000 to your loan in closing costs, it’s going to take a while to make up those costs with the monthly savings. Just make sure you will be in the home long enough to justify that (or feel like you have a need for that $100/month).

At the end of the day mortgage insurance is not inherently bad. The more you know about it the easier it is to understand and to decide if it works best for your circumstances.