A mortgage insurance policy is the lender's way of telling you "OK, we'll give you this loan, but we're not quite sure yet that you can follow through with the obligation." It's a little bit of a bummer to hear that you'll have to pay yet another expense with your mortgage payments in addition to property taxes and insurance, but the good news is that the payments don't usually last forever.
Mortgage insurance is a policy established to protect a lender from a situation where the borrower can't make his mortgage payments. Mortgage insurance premiums (MIP) are commonly associated with FHA (Federal Housing Administration) loans but some private companies also offer these policies. The policy mitigates the lender's loss due to the loan—it either reduces or completely covers any loss due to a homeowner's default. The borrower makes the first premium payment at mortgage closing and then either once per year or monthly. In some cases the borrower can make one lump-sum payment instead of installments over the course of the loan.
Avoiding Mortgage Insurance
Generally, the lender charges this premium if the borrower cannot put at least 20 percent down on the home purchase. When a homeowner puts a down payment on a house, he has made a personal investment into the home's equity. This reduces the bank's risk because the borrower is more invested in the purchase (he has put a significant amount of his own cash into the home) and the lender is more likely to get his money back from a future sale of the house in case of a default on the loan. So if you want to avoid mortgage insurance, you'll have to gather a minimum 20 percent down payment before closing the loan.
Though the existence of mortgage insurance premiums mostly benefits the lender, there are a couple of benefits of paying them as the borrower. If you itemized deductions, in some cases you can deduct all or part of the amount that you paid in the previous year for mortgage insurance. The amount is deducted on Schedule A (Itemized Deductions) under the "Interest You Paid" section. Also, since the lender allows a lower down payment, paying a mortgage premium allows the borrower to keep money to spend on initial home needs, like fixing up the house or buying furniture.
Getting Rid of Mortgage Insurance
The law requires lenders to remove mortgage insurance once the loan balance reaches 78 percent of the value of the home. Also, if you can prove that the loan-to-value (LTV) ratio is 80 percent or lower, the lender may decide to remove the mortgage insurance premium condition from your loan early. Divide the current loan balance by the home's market value (you can estimate using an online real estate valuation service or appraiser) to determine the LTV.