Mortgage Insurance: What It Is, How It Works, Types

What Is Mortgage Insurance?

Mortgage insurance is an insurance policy that protects a mortgage lender or titleholder if the borrower defaults on payments, passes away, or is otherwise unable to meet the contractual obligations of the mortgage.

Mortgage insurance can refer to private mortgage insurance (PMI), qualified mortgage insurance premium (MIP) insurance, or mortgage title insurance. What these have in common is an obligation to make the lender or property holder whole in the event of specific cases of loss.

Mortgage life insurance, on the other hand, sounds similar but is designed to protect heirs if the borrower dies while owing mortgage payments. It may pay off either the lender or the heirs, depending on the terms of the policy.

How Mortgage Insurance Works

Mortgage insurance may come with a typical monthly premium payment or be capitalized into a lump-sum payment at the time of mortgage origination. The type of mortgage insurance you need can depend on various factors, including the type of mortgage and the size of your down payment.

Here are three types of mortgage insurance:

Private Mortgage Insurance (PMI)

Private mortgage insurance (PMI) is a type of mortgage insurance that mortgage lenders may require borrowers to purchase if they make a small down payment. Like other kinds of mortgage insurance, PMI protects the lender, not the borrower. The lender arranges PMI, and private insurance companies issue the policy.

Mortgage lenders typically lend an amount that equals 80% of the property's selling price—called the loan-to-value (LTV) ratio. As a result, the homebuyer must come up with a 20% down payment due at the loan closing.

Borrowers who make a down payment of less than 20% must pay PMI to protect the lender. A lender might also require PMI if a borrower is refinancing with a conventional loan and equity is less than 20% of the home's value.

The borrower can request the cancellation of private mortgage insurance once the loan balance equals 80% of the original home's value at the time you purchased it.

Qualified Mortgage Insurance Premium (MIP)

When you get a United States Federal Housing Administration (FHA)-backed mortgage, you must pay a qualified mortgage insurance premium (MIP), which provides similar insurance to PMI.

Typically, the borrower must pay a monthly insurance premium plus an upfront mortgage insurance premium (UFMIP) of 1.75% of the loan amount due at the loan closing. However, the borrower can embed the upfront premium into the loan balance, paying for it via the monthly payments.

A mortgage insurance premium has different rules, including that everyone with an FHA mortgage must buy this type of insurance, regardless of the size of their down payment.

Mortgage Title Insurance

Mortgage title insurance protects against loss if a sale is later invalidated because of a problem with the title. Mortgage title insurance protects a beneficiary against losses if it is determined at the time of the sale that someone other than the seller owns the property.

Before mortgage closing, a representative, such as a lawyer or a title company employee, performs a title search. The process is designed to uncover any liens placed on the property that would prevent the owner from selling. A title search also verifies that the real estate being sold belongs to the seller. Despite a thorough search, important pieces of evidence can get missed when information is not centralized.

Mortgage Protection Life Insurance

As a borrower, a financial representative may offer mortgage protection life insurance when you apply for a mortgage. You can decline this insurance, but the bank may require you to sign some forms and waivers verifying your decision and that you understand the risks associated with having a mortgage.

Payouts for mortgage life insurance can be either declining-term (the payout drops as the mortgage balance drops) or level, although the latter costs more. The recipient of the payments can be either the lender or the heirs of the borrower, depending on the terms of the policy.

The Bottom Line

Mortgage insurance protects the lender if you cannot meet your mortgage obligations. Lenders require you to pay for private mortgage insurance if you put down less than 20% on a conventional loan, but you can request to drop the insurance once you have sufficient equity.

Depending on the type of government-backed FHA loan, you may pay a mortgage insurance premium for 11 years or the life of the loan.