'Mortgage Insurance' is explained in detail and with examples in the Real Estate edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Mortgage Insurance refers to a policy that helps would-be homeowners to buy a house with a smaller amount of down payment than traditional bank mortgages require upfront. It is these large typically 20 percent down payments that keep many people from the American dream of home ownership. Such insurance is also known by its popular acronym MI.
Thanks to private mortgage insurance, individuals are able to buy a house and put down a smaller amount than 20 percent. Most lenders and investors alike will insist on such mortgage insurance on any down payment that amounts to under 20 percent. Such MI gives lenders the peace of mind and financial backing that if a loan falls into foreclosure, they will receive financial compensation. This kind of guarantee helps many (if not most) lenders to work with less than the standard 20 percent down payment in home loan scenarios.
The real world application of such MI happens like this. A home buyer wants to purchase a $200,000 house. He is only able to put down 10 percent, amounting to $20,000, for his down payment. The lender will then get the privately issued mortgage insurance on the remaining $180,000 which is the mortgage amount. This will reduce the lender’s total exposure from $180,000 down to $150,000. This is because the MI will cover the top 25 percent to 30 percent of the mortgage amount. In this example, the MI has protected 25 percent, or $30,000 beyond the $20,000 down payment, from any end-losses the lender would take in the event of foreclosure on the house. Meanwhile the monthly premiums will become a part of the monthly mortgage payment amount, added on to the monthly amount due for the mortgage repayment.
There can be no doubt of the clear advantages this offers lenders. Yet home buyers also gain from MI in several important ways. The first of these is that they are able to purchase a house far sooner than they would be able to otherwise if they had to save an entire 20 percent standard down payment up themselves. It also boosts their ultimate buying power since they are no longer required to put down a full 20 percent. It is partially refundable according to a pro-rated schedule of premiums when it is cancelled through selling the house before the mortgage has been paid off. PMI helps to secure quicker approvals for home buyers. Finally, home buyers gain greater cash flow alternatives and flexibility on money that they do not have to put down at closing and tie up with the purchase of the house.
Most MI policies are allowed by the lender to be cancelled out after the loan balance declines to less than 75 percent to 80 percent of the total value of the house. The associated premiums also can be paid according to flexible means with many policies. Some will allow buyers to pay for part or even the entire premium in an initial lump sum during closing so that the monthly premiums will be lower. In either case, the policy can be cancelled when it is no longer needed or the buyer sells the house and pays off the mortgage in the process.
Some lenders will offer to pay the MI premium on the behalf of the home buyer. This is rarely done for free however. The tradeoff to the home buyer is that the lender will boost either the interest rate throughout the life of the mortgage loan or the fees they assess at closing time. This is why it is so critical to understand what the costs are when a lender offers to cover the premium on private mortgage insurance.