Mortgage insurance is an insurance policy which compensates lenders or investors for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer.
For example, suppose Mr. Smith decides to purchase a house which costs $150,000. He pays a 10% ($15,000) down payment and takes out a $135,000 ($150,000-$15,000) mortgage on the remaining 90%. Lenders will often require mortgage insurance for mortgage loans which exceed 80% (the typical cut-off) of the property’s sale price. Because of his limited equity, the lender requires that Mr. Smith pay for mortgage insurance that protects the lender against his default. The lender then requires the mortgage insurer to provide insurance coverage at, for example, 25% of the $135,000, or $33,750, leaving the lender with an exposure of $101,250. The mortgage insurer will charge a premium for this coverage, which may be paid by either the borrower or the lender. If the borrower defaults and the property is sold at a loss, the insurer will cover the first $33,750 of losses. Coverages offered by mortgage insurers can vary from 20% to 50% and higher.
To obtain public mortgage insurance from the Federal Housing Administration in the United States, Mr. Smith must pay a mortgage insurance premium (MIP) equal to 1 percent of the loan amount at closing. This premium is normally financed by the lender and paid to FHA on the borrower’s behalf. Depending on the loan-to-value ratio, there may be a monthly premium as well. The United States Veterans Administration also offers insurance on mortgages.