What is Mortgage Insurance?

Mortgage insurance, also known as private (PMI) or lenders mortgage insurance (LMI), is an insurance policy protecting lenders from the potential default of borrowers. The policy is purchased by the lender, and the premiums are passed along to borrowers as a fee tacked onto the monthly mortgage payment. Mortgage insurance is typically required for mortgages for which the down payment is less than 20% of the purchased property's value.

To qualify for mortgage insurance, a mortgage may have to meet conditions set by the Federal National Mortgage Association (Fannie Mae). These conditions cover borrower qualifications, the type of property being borrowed against, and the size of mortgage. If the conditions are met, the insured mortgage becomes eligible for resale in the very large and liquid market for mortgage-backed securities. This allows lenders to make, or originate, more loans than they might otherwise be able to handle because older mortgages can be sold.

The cost of mortgage insurance can also be incorporated directly into the mortgage in a process called capitalization. When capitalized this way, the premium becomes an additional tax deduction in jurisdictions where mortgage payments are tax deductible.

Not all borrowers can afford the 20% down payment necessary to avoid paying mortgage insurance premiums. To assist these borrowers, a financing technique known as 80-10-10 was created. While the primary or first mortgage remains at 80% of the property's value, the down payment is reduced to 10% with additional funds coming from a second mortgage. While the second mortgage carries a higher interest rate than the larger first mortgage, the elimination of mortgage insurance allows the debt to be paid down faster. Once the borrower's equity rises to 20%, the mortgages can be combined without the need for mortgage insurance. A variant known as 80-15-5 may also be available to home buyers with only enough cash for 5% down.

In the early 1990s, mortgage insurance became the focus of a mild controversy. With mortgages being bought and sold in the secondary market, homeowners were sometimes charged for mortgage insurance long after they had crossed the 20% equity threshold. After a brief congressional inquiry, many homeowners received rebates from lenders and reporting regulations were strengthened to prevent a recurrence.