Mortgage Insurance Premium or PMI is an insurance program to protect the lender if the borrower defaults on an FHA loan. An FHA (Federal Housing Administration) loan is a government-backed loan where the downpayment for a home can be as little as 3.5% of the purchase price. The government guarantees the loan and adds a layer of financial protection for the lender.
Because of the low downpayment requirement and a lower threshold of acceptable credit scores, FHA loans tend to be higher risk than a conventional loan. As a result, mortgage insurance premiums help make FHA loans safer for banks. In case of foreclosure, the MIP will reimburse the lender.
In a conventional loan from a private lender, such as a bank, buyers must have private mortgage insurance or PMI if they do not have a significant downpayment. Usually, this number is around 20%. In other words, if you do not have at least 20% down, your lender will require you to mitigate some of their risk by purchasing private mortgage insurance. The cost of your PMI varies with the size of your loan and your downpayment percentage.
If you have PMI, you will likely need to pay a premium every month. This cost is usually lumped in with your monthly repayment.
FHA loans have a similar set up to private mortgage insurance. If your downpayment is less than 20%, the FHA loan will require a mortgage insurance premium. FHA will require you to pay an upfront MIP at the time of closing and an annual MIP, which is calculated every year and paid in 12 monthly installments.
The current upfront mortgage insurance premium or UFMIP is 1.75% of the FHA loan amount. For example, if you take out a $250,000 FHA loan, $4,375 will be added to your closing expenses, along with your mortgage principal, interest, property taxes, and homeowners insurance. You can pay this amount in cash, or finance it into the loan.
The annual mortgage insurance premium is usually between 0.45% and 1.05%. Your annual cost will be determined by the terms of the loan, your loan amount, and the loan-to-value ratio. The annual premium is then divided into 12 months and added to your monthly installment. For example, if your annual MIP is 0.55%, you would multiply this by your new loan amount. In our previous example, your new loan amount is $250,000 plus $4,375, or $254,375. 0.55% of the new loan amount is $1,399.06. If you divide that into 12 months, you will likely have a $116.58 monthly add-on to your mortgage payment.
In June 2013, canceling your MIP became significantly more difficult.
If you made a downpayment of 10% or more, you will need to pay MIP for 11 years. Unfortunately, MIP is now required for the life of your loan if you made a downpayment of less than 10%. The only want to cancel your MIP is to refinance your FHA loan to a non-FHA or conventional loan.