What is Morgage Insurance or PMI?

The most common loans in America require the home buyer to buy mortgage insurance, but what is it? At first glance, you might think that mortgage insurance is a product where the insurance company will make a payment for the buyer if they lose their job or get into financial trouble. The truth is that the buyer does not benefit from mortgage insurance. The lender does. The way it works is the lender only sees value in lending to people who can put down large down payments. This way, if the borrower doesn’t make the payment, the lender can take the property back, sell it quickly and recoup their investment, and possibly a little more than their investment. After the stock market crash in the 1920’s in the US, no lender wanted to lend to a borrower unless they put down at least 20%. This same standard has continued until today.

It was very difficult for people to get loans at the time because they didn’t have the 20% that was required of them. This was the case until the 1950’s. Someone came up with a great idea! What if I offered an insurance policy that would insure the bank would get their money if the borrower didn’t make their payment and lost the house?! Mortgage insurance, which had existed prior to the 1920’s, was reborn. The same standard is used today…if you’re buying a house with less than a 20% down payment, you have to pay for mortgage insurance to insure the bank against your (the buyer’s) default.
So how does it work?

Let’s say you buy a $200,000 home and only put $20,000 down. This means you have a loan for $180,000, or 90% of the loan. You will get an insurance policy equal to between 0.3% and 1.5% of the mortgage in payments per year until the principle balance is reduced below the 80% value of the house, or $160,000 in this case. Let’s now say you, as the borrower, default on your loan after making 0 payments. You still owe $180,000. The bank forecloses on you. The bank will try to sell it for $180,000. If they can only sell it for $170,000, the mortgage insurance company pays out a claim to the lender for the $10,000 difference between what they sold the property for and what was lent to you, the borrower.
As you can see, mortgage insurance is meant to help the lender, not the borrower; however, in a roundabout way, the borrower is helped, too, because they are allowed to make a smaller down payment, pay a premium on top of their normal mortgage payment, and can buy a house. Without mortgage insurance, fewer people would be able to buy a house. It was because of mortgage insurance that there was a real estate boom in the 1950’s and 1960’s. It was many of the mortgage insurance companies in 2007 who went belly up, but at least now you know what you were paying extra for.

FHA loans use government backed mortgage insurance companies. Conventional loans with less than 20% down can use PMI, or private mortgage insurance. The ideas and methods are the same.

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