Wondering what the difference is between mortgage insurance vs. homeowners insurance? When you borrow money to purchase property, lenders will use every tool in their toolkit to minimize risk. For borrowers only making a small down payment, requiring you to carry mortgage insurance is one tool. Another tool is requiring you to carry homeowner’s insurance.
If you buy a property with a mortgage and your down payment is lower than 20% of the purchase price, you can expect to pay mortgage insurance. You also need to pay homeowner’s insurance to protect both the lender and yourself.
Mortgage insurance vs. home insurance
Mortgage insurance and homeowners insurance share the same last word, yet exist for different purposes. Assuming you are borrowing money from a bank, one might be required, the other will be required. Each type of insurance meets a different need, but if the unthinkable happens, your mortgage provider wants to know you carry enough insurance to protect their investment. Now let’s learn more about these two different types of insurance.
When homeowners consider insurance, it’s often considered a singular term. You’ve seen the ads: “Got Milk?” Many homeowners think “insurance” is a single item that gets checked off the list. There are different types of insurance serving different purposes.
Why mortgage insurance?
Mortgage insurance is similar to life insurance. You buy life insurance to provide your family with income protection in case something happens to you. They get a cash lump sum which they can invest to earn interest, providing income replacement.
Mortgage insurance provides a similar type of protection for the lender, specifically the bank that granted you the mortgage. If something happened to you and you died, the bank realizes you aren’t around anymore to continue making those monthly mortgage payments. The bank is in the business of establishing loans and collecting on them, not owning houses. Mortgage insurance pays off a lump sum upon your death, compensating the bank. It also provides coverage if you were still alive, but stopped making payments or defaulted on the mortgage. The protection is in place to limit the bank’s losses.
Why homeowners insurance?
Homeowners’ insurance exists for a different purpose. If mortgage insurance provides protection relating to the loan, homeowners insurance provides protection for the physical structure and its contents.
Why should the bank be concerned about damage to your furniture and appliances? They aren’t that concerned. They worry about the structure itself. The bank loaned you the money to buy the house and land underneath it. It was a package deal. Although the land has value, generally speaking, it’s worth a lot less if it no longer has that nice house sitting on top of it. If tragedy struck, the bank wants to know you have the cash available to get your house repaired and returned to its original condition. They want you to protect their investment.
What is mortgage insurance?
Mortgage insurance is like life insurance, only your mortgage provider is the beneficiary if you died. It’s a form of protection for the mortgage provider, especially if you are putting down a smaller down payment. It isn’t only protection in case of your death. If you stopped making payments and default, it provides protection for the lender. It stays in place until you have paid the mortgage down by a certain amount, increasing your equity in the property.
When is mortgage insurance required?
There are two main scenarios where you are required to have mortgage insurance: if your down payment is below 20% or if your mortgage is backed by certain federal loan programs.
Your down payment is below 20% of the purchase price
Mortgage insurance is generally required if you are putting down less than 20% as a down payment.
If you walk into a bank, meet the basic criteria like income and credit score, yet can’t put down a 20% deposit, the bank might still give you the loan with a lower down payment anyway, but they will be requiring mortgage insurance. In this case, the insurance is likely to come from an insurance company. It’s called Private Mortgage Insurance, to differentiate it from insurance through a Federal government agency.
Your mortgage is backed by federal loan programs
Federal loan programs make it easier to qualify for competitive rates and terms. However, they usually require an upfront mortgage insurance premium and an annual premium.
1. FHA Loans
The Federal Housing Administration guarantees loans for borrowers who might not meet conventional criteria. This often means making a lower down payment or having a lower credit score. They require borrowers to also pay a mortgage insurance premium or MIP. This protects the lender. FHA mortgage insurance typically costs 1.75% upfront plus an annual fee of about 0.45% – 1.05% spread across your monthly payments.
2. USDA Loans
The United States Department of Agriculture also insures loans, typically in rural areas. These don’t require down payments, therefore the lender wants protection. There is a 1% charge upfront plus an annual charge of 0.35%, also spread across your monthly payments.
3. Veterans Administration Loans
The US government has a lot of respect for people who served their country in the military. The agency, known as the VA for short, enables veterans to buy homes without a down payment. In the is case, it’s called a funding fee is an upfront charge, typically 1.4% to 3.6%. This fee is added to the amount borrowed (and financed) or paid in full upfront.
Is Mortgage Insurance Included in Your Mortgage?
This depends on how you define “included.” If you mean the monthly amount you pay to your mortgage company, the answer is yes. Your mortgage payment consists of three components: Principal, interest, and everything else. That third category, termed escrow includes payments made for additional expenses like property taxes and insurance costs.
Why do they take on the responsibility of collecting for and paying these additional fees? Don’t they trust you? The simple answer is No. A more charitable view is they want to be sure taxes and insurance are paid on time, in case you were busy and forgot. As an FYI, your mortgage service company settles up with you at the end of the year, sending you a statement concerning what you paid into the escrow account and what they dispersed. Costs go up, so they will let you know if you need to make up a shortfall or be paying a higher amount in the next year. That’s one reason why your mortgage payments go up, even though you might have a fixed rate mortgage.
Will I be paying mortgage insurance forever?
Not necessarily. It’s important to revisit the reason you are required to pay mortgage insurance: On a conventional mortgage, your down payment was below a threshold, often 20%. Over time, those principal payments you make on your mortgage add up, reducing the size of the loan. Once your piece of the pie is over 20% and the bank’s slice is under 80%, they might not require mortgage insurance going forward.
One way to try and get mortgage insurance out of the picture is to seek to refinance your mortgage.
What is PMI?
Earlier we looked at certain situations where the federal government guarantees or insures mortgages. If you are a regular person borrowing from a bank, you might not fall under federal programs. If your down payment is under 20% and the bank is agreeable to lending, they will require mortgage insurance, from a conventional provider. This is called Private Mortgage Insurance, or PMI.
The graph below shows some of the ways in which mortgages with a PMI differ from mortgages that don’t.
What is homeowners insurance?
Homeowners insurance protects the physical property and contents of your house. It’s similar to collision insurance for your car. Your policy is subject to a deductible, meaning you as the property owner are expected to pay a certain portion of the repair costs. Put another way, if your “out of pocket” deducible is $ 5,000, the first $ 5,000 worth of repairs gets paid by you. The size of the deductible and the annual insurance premium are correlated. Lower deductibles mean higher premiums and higher deductibles mean lower premiums.
Homeowners’ insurance policies are subject to exclusions. These are big events like floods and earthquakes. You might think protecting yourself against natural disasters is the whole point of buying insurance. Insurance companies seek to limit their liability. In many cases, you can protect yourself against the excluded events by purchasing additional insurance specific to those tragedies. Flood insurance and earthquake insurance are two examples.
Homeowners’ insurance is known by different names. It might be called property insurance or hazard insurance.
The mortgage provider sees the value of the property in both the land and the structures. They want you to maintain the structure and rebuild if tragedy strikes. Therefore, they will likely require property insurance. Their primary concern is the building itself, not your possessions.
Generally speaking, insurance companies aren’t required to insure everyone. An insurance company might choose to “pull out” of a state if they want to limit their risks. They might assign a lifespan to the roof on your house, requiring it to be replaced after a certain number of years if you want to continue your insurance coverage. Then the homeowner needs to either make the repairs or shop around to find another insurance carrier.
When is homeowners insurance required?
If you own your home free and clear, homeowners insurance probably isn’t required. If you are borrowing money through a mortgage, loan is secured by the property and the bank will want you to be carrying insurance for at least the replacement value.
Here’s the logic: Mortgage insurance covers your life. The bank hopes you live a long life and make your monthly mortgage payments like clockwork until the mortgage is paid off. If you die, that’s a one-time event. It also protects the lender if you default.
Let’s assume you have a 30-year mortgage and live in your house. Over three decades there may be many different storms with the potential to damage your property. Fire is a risk. It might have started in an adjacent building. The bank wants to protect its loan against loss. They will want you to carry insurance for replacement value at least to the remaining value of the loan.
Is homeowners insurance included in your mortgage?
Your lender wants to be confident those insurance coverage bills are paid. This is another expense, like property tax payments, that is included in your escrow.
Do I need homeowners insurance after my mortgage is paid off?
A better question is “Are you required to carry homeowners insurance once your mortgage is paid off?” At that point, the bank is out of the picture. You own your home free and clear. The bank isn’t making your property tax and insurance payments through the escrow they have been collecting. That is your responsibility now.
Although you might not have to carry it, you would be foolish not to have homeowner’s insurance.
Is mortgage insurance different than homeowners insurance?
Yes, there is a difference. Mortgage insurance protects the lender in case the borrower dies, defaults or stops making mortgage payments. Homeowner’s insurance covers the physical structure, providing money for the homeowner to repair damage to their property. It’s subject to deductibles and exclusions.
Is homeowners insurance required with a mortgage?
Yes. From the lender’s point of view, the value of the property is in both the land and the structure. Homeowner’s insurance protects the structure.
Is mortgage insurance a waste of money?
No, although it might depend on your point of view. Suppose the bank refuses to give you a mortgage because your down payment is too small unless you carry mortgage insurance? You won’t get the house unless you comply. You might think it’s a level of protection you don’t need because “your word is your bond” and you promise to make the mortgage payments for the life of the loan. No one knows what the future holds. From the lenders’ point of view, mortgage insurance is a great idea because it allows them to approve borrowers that would otherwise be to risky to consider.
Do you need homeowners insurance if you don’t have a mortgage?
The importance of homeowner’s insurance remains constant. When you have a mortgage, the lender wants protection for the structure because a large amount of value resides in it. When you don’t have a mortgage, you still want to protect your home from harm. The building represents a lot of the property’s value.
- Mortgage insurance usually enters the picture when your down payment is less than 20%
- Mortgage insurance protects the lender in case you die, default or otherwise cease making payments.
- Homeowner’s insurance protects the structure and contents.
- Both types of mortgage payments are made through the escrow account.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book, “Captivating the Wealthy Investor” is available on Amazon. Bryce spent twenty years with a major financial services firm as a successful financial advisor. He has been published in 40+ metro market editions of American City Business Journals, Accountingweb, NAIFA’s Advisor Today, The Register, LifeHealthPro, Round the Table, the Financial Times site Financial Advisor IQ and Horsesmouth.com.