With conventional loans, if the initial down payment is less than 20% of the total loan amount, the borrower will have to pay for private mortgage insurance (PMI).
Without the insurance, the small down payment would mean the borrower doesn’t have much stake in the property, and would therefore be at too high of a risk of defaulting for a lender to make the loan.
FHA loans do not fall into the conventional category, so they have their own type of insurance called a Mortgage Insurance Premium (MIP).
If you have a conventional loan, it’s possible to avoid PMI by putting more than 20% down. The whole point of FHA loans is that they have loose requirements—such as a minimum down payment of only 3.5%—which make it easier for lower income borrowers to obtain loans.
Obviously, the 3.5% is a very small amount down, which is why every borrower is forced to pay MIP in order to insure the lender against the potential default on the mortgage. There are two types of MIP.
1. Upfront MIP
Currently, the FHA has an upfront mortgage insurance premium (UFMIP) of 1.75% of your loan amount. While upfront MIP does get added after the loan is closed, it does not need to be paid immediately. What happens is the Federal Housing Administration takes 1.75% of the original loan amount, and adds it to the loan.
So if you had a $200,000 loan, they would take 1.75% of that ($3,500) and add it to your loan to get a new loan amount of $203,500. If you’re wondering how this affects your loan-to-value ratio, the answer is that it doesn’t. The initial loan amount (in the example it would be $200,000), is still used to calculate LTV.
2. Annual MIP
Annual MIP is required for all FHA mortgages, and is paid in 12 installments per year. It gets factored right into your monthly mortgage payment, and will most likely to be itemized as HUD Escrow, Risk-Based HUD, or Monthy Mortgage Insurance, rather than FHA mortgage insurance.
The amount you’ll have to pay will be determined by the specifics of your loan and when your loan began (the FHA has changed MIP requirements several times over the past ten years).
When does it stop?
When the loan was originated, the amount of your down payment, and the current loan-to-value ratio all affect when a borrower will stop paying MIP. However, with most loans MIP gets dropped once the LTV reaches 78%.
For borrowers who don’t want to wait, or who have loans that don’t drop MIP at 78% LTV, there is the option of refinancing. As mortgage insurance rates are lower, and payments stop once your home has 20% equity, refinancing into a conventional loan is a common occurrence for borrowers with FHA loans.