What Is Mortgage Insurance? How It Works, When It’s Required

Mortgage insurance makes it possible to put down less than 20% to buy a house and still qualify for a home loan.

You pay for the coverage, which compensates the lender if you default on the mortgage. The cost and other details vary by the type of loan.

» MORE: What is PMI?

How does mortgage insurance work?

Mortgage insurance pays the lender a portion of the principal if you stop making mortgage payments. However, you're still on the hook for the loan, and you could lose the home in foreclosure if you fall too far behind.

This coverage differs from mortgage life insurance, which pays off the remaining mortgage if the borrower dies, or mortgage disability insurance, which pays the mortgage for a certain period if the borrower becomes disabled.

PMI vs. MIP

Here's what you need to know about mortgage insurance for conventional loans, which are not federally guaranteed or insured, and FHA mortgages, backed by the Federal Housing Administration.

PMI for conventional mortgages

Many lenders offer conventional mortgages with low-down-payment requirements — some as low as 3%. However, a lender likely will require you to pay for private mortgage insurance, or PMI, if your down payment is less than 20%.

Before buying a home, you can use a PMI calculator to estimate the cost of PMI, which will vary according to the size of your home loan, your credit score and other factors. Typically, the monthly PMI premium is included in your mortgage payment. You can ask to cancel PMI after you have over 20% equity in your home.

» MORE: Calculate your PMI costs

FHA mortgage insurance premium

FHA loans feature minimum down payments as low as 3.5% and have easier credit qualifications than conventional loans. However, most FHA home loans require an upfront mortgage insurance premium or MIP and an annual premium regardless of the down payment amount.

The upfront premium is 1.75% of the loan amount and is due when the mortgage closes. You can pay in cash or roll the amount into the loan.

The annual MIP is paid in monthly installments for the life of the FHA loan if you put down less than 10%. If you put down more than 10%, you pay MIP for 11 years. The annual premium ranges from 0.15% to 0.75% of the average outstanding loan balance. The fee varies depending on your down payment, loan amount and loan term. Most home buyers will pay 0.55%, according to the FHA. 

» MORE: Is an FHA loan right for you?

Fees for USDA and VA loans

USDA loans, guaranteed by the U.S. Department of Agriculture, and VA loans, backed by the U.S. Department of Veterans Affairs, don't require mortgage insurance. Still, they have borrower-paid fees to protect lenders.

USDA guarantee fee

USDA loans are zero-down-payment loans for rural home buyers. USDA loans issued by lenders have two fees: an upfront guarantee fee paid when the mortgage closes and an annual fee paid every year for the life of the loan. The upfront guarantee fee is 1% of the loan amount. The annual fee is 0.35% of the average outstanding loan balance for the year, which is divided into monthly installments and included in your mortgage payment. The federal government evaluates the fees each fiscal year and can change them. But your fee amount will not fluctuate; it is fixed when the loan closes.

» MORE: Is a USDA loan right for you?

VA funding fee

VA mortgages require no down payment and feature low interest rates for active, disabled or retired military service members, certain National Guard members and reservists, and eligible surviving spouses. These loans don't require mortgage insurance, but most borrowers will pay a funding fee ranging from 1.25% to 3.3% of the loan amount for purchase loans. The fee varies based on your down payment amount and whether this is your first VA loan.

The funding fee for an Interest Rate Reduction Refinance Loan, or IRRRL, is 0.5%, and the fee for a VA cash-out refinance is 2.15% for the first such loan and 3.3% for subsequent loans.

» MORE: Is a VA loan right for you?

How to avoid mortgage insurance

Some state first-time home buyer programs offer low-down-payment mortgages with no or reduced mortgage insurance requirements.

But generally, you'll need to get a conventional mortgage and put at least 20% down toward a home to avoid mortgage insurance.

If that's not possible, then budget in the cost of mortgage insurance or VA or USDA fees when calculating how much home you can afford.