Understanding the ins and outs of the homebuying process can be complex, especially regarding insurance. Two types of insurance often come up in this process: mortgage insurance and homeowners insurance. They may sound similar, but each serve very different purposes that every current or prospective homeowner should be aware of.
Understanding Mortgage Insurance
When it comes to mortgage insurance, there are two types to consider: private mortgage insurance (PMI) and Federal Housing Administration (FHA) mortgage insurance.
Private Mortgage Insurance (PMI)
PMI is an extra expense added to your monthly mortgage payment. Lenders usually require PMI if you make a down payment of less than 20% of the home’s purchase price. PMI is designed to protect your lender if you stop paying your loan, since they are assuming more risk by extending a larger loan and demanding less cash upfront from you.
Federal Housing Administration (FHA) Mortgage Insurance
An FHA loan is a government-backed loan that allows you to purchase a home with less strict financial requirements, making it a popular choice for first-time home buyers or people with low credit scores. However, mortgage insurance is required on all FHA loans, regardless of the down payment amount. Like PMI, FHA mortgage insurance protects the lender if you default on your loan.
Key Components of Homeowners Insurance
Homeowners insurance helps protect you if the unexpected happens to your home or property. You may ask: What does my homeowners insurance cover? Here are some common coverages you may see on a homeowners insurance policy:
- Dwelling coverage: This coverage may help pay to repair or rebuild the physical structure of your home if it's damaged by a covered loss, such as fire, windstorms, or vandalism. Your “dwelling” refers to the main house and its attached structures, such as a garage or porch.
- Personal property: This coverage helps pay to replace your belongings — e.g., furniture, electronics, appliances, etc. — if they get damaged or destroyed due to fire, theft, or another covered loss.
- Extended replacement coverage: This coverage helps extend your dwelling coverage by a certain percentage if the cost to rebuild or replace your home exceeds your policy’s limits.
- Additional living expenses: If your home becomes uninhabitable due to a covered loss, this coverage helps provide you with additional living expenses, such as hotel accommodations and meals.
- Personal liability protection: This coverage helps provide financial protection if you or someone else in your household is found legally responsible for causing bodily injury or property damage to another party.
- Guest medical protection: If guests injure themselves while on your property, this coverage helps pay for their medical expenses.
Differences in Coverage
When comparing mortgage and homeowners insurance, it's crucial to understand that these two types of coverage serve different purposes and offer distinct types of protection.
- Mortgage insurance: Mortgage insurance is designed to benefit the lender. It safeguards the lender's investment by ensuring they can recoup their losses if you — the borrower — default on monthly mortgage payments. It doesn't protect you or cover any physical damage to your home or personal property.
- Homeowners insurance: Homeowners insurance is designed to protect the homeowner. It typically covers damage to the home and other structures on the property, personal property inside the home, and liability for injuries or damages that occur on the property.
The coverage period is a crucial aspect that distinguishes mortgage insurance from homeowners insurance. Both types of insurance serve specific purposes and come into play at different stages of homeownership, each with its own duration and conditions.
- Private mortgage insurance: The coverage period for PMI is tied to the loan-to-value ratio — i.e., the amount of the mortgage compared to the property’s value. This means that the duration of mortgage insurance can vary greatly depending on your repayment schedule and your home's appreciation rate. However, PMI is temporary. According to the Consumer Finance Protection Bureau, lenders must automatically terminate PMI on the date when your principal balance is scheduled to reach 78% of your home’s original value, or once you reach halfway through your loan’s term.
- FHA mortgage insurance: Depending on your down payment amount, you’ll have to pay for FHA mortgage insurance for at least 11 years, or the length of the loan. Unlike PMI, you can’t cancel FHA mortgage insurance. To remove it, you’ll have to refinance it to a non-FHA loan once you have enough equity.
- Homeowners insurance: Homeowners insurance is an ongoing policy that remains in effect as long as you continue to pay the premiums. Generally, you can renew your policy annually. You also have the flexibility to review and modify your coverage over time, ensuring it aligns with the evolving value of your property and personal assets.
Costs and Premiums
Navigating the financial aspects of homeownership involves understanding the costs and premiums associated with both mortgage and homeowners insurance.
Cost Structure of Mortgage Insurance
The cost of mortgage insurance depends on the type of loan you have.
Private mortgage insurance: PMI costs are often structured as monthly premiums, which are added to your mortgage payment. The monthly premium amount is calculated based on factors such as the loan-to-value ratio, credit score, and the down payment size. Generally, you should expect to pay anywhere from 0.3% to 1.5% of the original loan amount annually for PMI. As mentioned earlier, lenders must stop PMI when the loan-to-value ratio reaches 78% or when you get to the halfway point of your loan's term. At this point, you've accumulated enough equity to mitigate the lender's risk adequately.
- FHA mortgage insurance: FHA mortgage insurance includes both an upfront and yearly premium. The upfront premium is 1.75% of the loan amount, paid at closing, while the yearly premium usually ranges from 0.45% to 1.05% of the loan balance, depending on the loan's term and loan-to-value ratio. This yearly premium is divided by 12 and added to your monthly mortgage payment.
Cost Structure of Homeowners Insurance
Homeowners insurance premiums are determined by various risk factors, including the property’s location, its age and condition, your claims history, and the coverage limits selected. Typically, you can pay for homeowners insurance premiums annually or monthly. Premiums remain relatively stable from year to year unless there’s a significant change in the home's value or the policy's coverage.
Additionally, some homeowners insurance coverages, such as dwelling coverage and personal property coverage, have a deductible — the out-of-pocket amount you agree to pay for a claim before your insurer begins to pay. Deductibles can range from $500 to $5,000. Generally, the higher the deductible you choose, the lower your premium will be. However, if you choose a higher deductible, ensure you have enough funds to cover it when you have to file a claim.
How They Work Together
Mortgage and homeowners insurance work together by providing a safety net for both parties involved in a mortgage agreement. If disaster strikes, homeowners insurance will cover the cost of repairing or rebuilding your home, which in turn protects the lender's investment. If you default on the loan, the mortgage insurance will cover the lender's loss.
While mortgage and homeowners insurance are two different types of coverage, they’re both essential in securing a mortgage for your home. In fact, most lenders require you to have homeowners insurance as part of the mortgage agreement. If you need a homeowners insurance policy, consider Mercury, where we offer cheap homeowners insurance without compromising quality. Talk with a local agent to learn more about the benefits of homeowners insurance.