What is mortgage insurance?
Whether it's called “private mortgage insurance” (PMI) or just plain “mortgage insurance” (MI), mortgage insurance is an insurance policy which protects the lender in the event that you, the borrower, fail to make your mortgage payments. You pay for a policy as an inducement for the lender to offer you financing.
Don't confuse PMI with credit life insurance. Mortgage insurance won't pay your mortgage each month should you become disabled, unemployed or deceased, and pays nothing to you or any of your beneficiaries.
A brief history
In general, if you can't (or don't want to) come up with a 20 percent down payment to buy your home, or don’t have a 20 percent equity stake when you refinance, you'll be required to purchase a private mortgage insurance policy as part of the mortgage process.
It's a tenet of mortgage lending that borrowers who don't have fairly substantial equity in their home are more likely to default. That's primarily why lenders insist that buyers borrow no more than 80 percent of the home price. Of course, having to come up with the other 20 percent -- in cash -- discourages many potential buyers who don't have such a large sum of money on hand.
In the early days of mortgage lending, the government-run Federal Housing Administration (FHA) was the only organization that would guarantee mortgage loans with low down payments. Although the program was immensely popular, getting an FHA loan (and MI) was such a cumbersome process that private firms began to compete.
While the FHA's self-insuring pool covers the lender against a borrower's default for the entire loan amount, PMI typically covers 30 percent or less, so it removes some (but not all) of the lender's risk of lending mortgage money to a low-down payment borrower. As such, should the borrower default, mortgage insurance can offset some, most or even all of the lender's loss.
Along with lenders and mortgage investors, mortgage insurers suffered considerable losses in the housing market downturn, with several going out of business altogether. At the moment, there are six prominent mortgage insurers: Essent Guaranty, National Mortgage Insurance Corporation, Genworth Mortgage Insurance, Radian Mortgage Insurance, ARCH Mortgage Insurance Company and Mortgage Guaranty Insurance Corporation (MGIC). Most policies are issued by one of these firms, although some larger lenders may self-insure the mortgages they make.
Overall, PMI is a good thing; it helps turn hundreds of thousands of would-be homebuyers into homeowners every year. It can become needlessly costly, though, if the policy runs on for years when it’s no longer needed.
Mortgage insurance confusion
If you get a new mortgage, you’ll probably get solicitations in the mail for a different kind of “mortgage insurance.” Unlike mandatory MI for a loan with a small down payment, these aren’t really mortgage insurance policies, but rather optional credit life-and-disability policies. They may sound tempting, promising to protect your family should you die, lose your job or become disabled. However, these can be costly, and you need to read the fine print before you consider signing up for one.
You’ll want to check the claims-paying record of the company offering the policy and their financial health, or at least see how they are rated by an independent rating agency like A.M. Best. Also, you may do better with other forms of more traditional insurance, such as a term life policy. Having a policy which pays off your mortgage is all well and good, but this may provide better protection for the lender, not your family. Often, your family won’t get the cash or have control of it should you pass away… and paying off the mortgage may or may not be the best solution for their needs.