What is mortgage insurance?

Many buyers find mortgage insurance confusing, particularly because, when you buy a home, you must purchase homeowners insurance (to protect your home in case of fire or a natural disaster) and title insurance (to protect your rights as an owner of the property against claims by other people). Even though you're the person who pays the bills, mortgage insurance provides protection for your lender in case you default on your loan.

You must pay mortgage insurance any time you buy a home with a down payment of less than 20 percent of the contract price because lenders view a mortgage with a loan-to-value of more than 80 percent as risky. Not only are borrowers more likely to default on a loan when they have little home equity, the lender risks not being able to get the full amount of the loan back in a foreclosure sale if the mortgage is almost equal to the value of the home. You're paying mortgage insurance to an insurance company so that the lender feels protected enough to offer you a loan. Private mortgage insurance (PMI) payments vary according to your loan-to-value, the size of your loan and your credit score. PMI payments must be automatically cancelled once your loan-to-value reaches 78 percent, typically in seven to nine years depending on the size of your down payment. If you make extra payments to your mortgage balance, you can eliminate the payments faster. You can also pay for an appraisal if you believe your home value has risen enough to reduce your loan-to-value.

FHA loans require mortgage insurance too; but because these loans are government-insured, the mortgage insurance isn't private. FHA insurance is often more costly than PMI and, unless you make a bigger down payment than the minimum of 3.5 percent, you'll have to pay it for the entire loan term.

Paying mortgage insurance of $50 to $100 a month or more does add to your monthly housing payment, but it also allows you to buy a house without having to save as much for a down payment or using all of your cash.

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