How Does Mortgage Insurance Work?

Mortgage insurance, or otherwise known as PMI or MI throughout the industry, is really just an insurance policy provided by a mortgage insurance provider. Although it is required on many loans when the loan amount is over 80 per cent of the value of the subject property that is being mortgaged, it is not always a requirement in sub-prime loans. In these cases, the borrower will generally pay a higher interest rate, rather then paying a premium for mortgage insurance.

Mortgage insurance is a protection for the lender. Even though they may be loaning out 90 percent of the value of the property through a purchase or refinance, with MI in place, the loan is guaranteed. If they retain and sell the property and only receive 80 percent of the value, even though the loan was based on 90 percent of it's value, the MI company will be responsible for the other 10 percent.

The borrower has to pay a mortgage insurance premium each month, which is added onto their regular mortgage payment. They must pay this until they have either gained enough equity over time so that the loan balance is 80 percent or less than the value of the property or they have paid down the loan balance to 80 percent or less of the value. In some cases lenders will also attach a seasoning requirement, meaning that they have to pay the MI for a minimum of two years.

The premium paid for mortgage insurance varies greatly. If you are only at 81 percent loan to value your premium will be much less than the person who is at 95 percent loan to value. Credit and other risk factors also will determine the cost of the MI. A higher risk borrower may have a substantially higher premium to pay than a low risk borrower, even though they may be at the same loan to value.

MI premiums must also be factored into the borrower's debt to income ratios. In some cases, due to MI premiums, a borrower may no longer even qualify for the loan. The only alternative to MI if you are over 80 percent loan to value is to try and qualify for a sub-prime loan for the same loan to value you need, but expect to pay a higher interest rate, which in some cases is even more costly than what the MI premium would be.