What is the Real Cost of Mortgage Insurance?

Mortgage insurance is a financial guaranty that insures lenders against loss in the event a borrower defaults on a mortgage. If the borrower defaults and the lender takes title to the property, the mortgage insurer (MGIC, for example) reduces or eliminates the loss to the lender. In effect, the mortgage insurer shares the risk of lending the money to the borrower. Mortgage insurance should not be confused with mortgage life insurance, which provides coverage in the event of a borrower's death, or homeowner's insurance, which protects the homeowner from loss due to damage from fire, flood or other disaster.

If you are buying a home and putting up a downpayment of less than 20 percent of the home's value, then generally you don't have a choice of whether to buy this type of insurance. The lender requires it. Why? Because PMI isn't there to protect you - it's there to protect the insurer in the event you default on your home loan and the lender isn't able to re-sell your home for enough money to pay off the mortgage.

The cost of PMI varies, but a rule of thumb is about one half of one percent of the loan amount. The second type of mortgage insurance is the type that usually goes by the name mortgage life insurance. Here, you're being offered the chance to buy an insurance policy that will repay your mortgage in the event of your death, disability or some incapacitating disease. One way around mortgage insurance is to structure your financing so that you can reduce the amount of your mortgage to no more than 80 percent of the purchase price. Most lenders don't require mortgage insurance on loans for 80 percent or less of the purchase price.

Let's say you are buying a $300,000 house and you have a 10 percent cash down payment. If you take a 90 percent loan for $270,000, many lenders will charge mortgage insurance. But if you get a first mortgage for $240,000 (80 percent of the purchase price) and a second mortgage for $30,000 (10 percent of the price), you could avoid paying mortgage insurance. This is called 80-10-10 financing. Some lenders will require mortgage insurance on 80-10-10 financing if the first mortgage is a conforming loan (loans in amounts up to $214,600 that are sold to Freddie Mac and Fannie Mae for resale to investors).