You may know there are conventional and government-backed mortgages. Government-backed mortgages are those that carry an inherent guarantee to the lender that owns the loan. These three loan types are VA, USDA and FHA mortgages. As long as the lender approved the loan using the required guidelines, the lender is compensated should the loan ever go into foreclosure. Sounds like a good deal, right? It is, and lenders like making these loans, even though they require very little down.

This guarantee however isn’t without cost. The guarantee is funded by a type of insurance premium that is paid for by the borrower with benefit to the lender. For FHA loans for instance, the minimum required down payment is 3.5% of the sales price.  To offset the increased risk for a lender making a loan with very little to nothing down, the government-backed guarantee accompanies the FHA loan and is financed with a type of mortgage insurance, or MI as lenders sometimes refer to it.

On FHA loans, there are two types of mortgage insurance on the same loan, one that is paid upfront and an annual mortgage insurance premium paid to the lender in monthly installments. The upfront premium is 1.75% of the loan amount. With a loan amount of $250,000 the upfront premium is then $4,375. This amount can be and usually is rolled into the original loan amount and doesn’t have to be paid for out of pocket. This premium is used to finance the government guarantee on the loan. The annual premium on a 30 year fixed rate loan is 0.85% of the outstanding loan amount and again using the same example that comes to $2,125 for the first year paid monthly at $177. Both premiums are for the life of the loan.

FHA loans can almost be thought of as an insurance program and less of a home loan. FHA does in fact write the rules for FHA mortgages and only FHA-approved lenders can issue them but because there mortgage insurance premiums involved and a government-guarantee, the insurance policy compensates the lender in case of a loss on the mortgage.

Borrowers with FHA loans do have the ability to get rid of mortgage insurance on FHA loans which reduces their overall monthly payment, when the loan reaches 78% of the original sales price and the 30 year mortgage is at least five years old, the annual mortgage insurance premium is no longer required. On a 15 year fixed rate FHA loan, there is no minimum amount of time the annual premium must have been paid. This 78% level is due to natural amortization but borrowers may also take advantage of home value appreciation as well as making extra payments on the mortgage to lower the loan balance and reach the magical 78% mark.

FHA mortgage insurance, as is mortgage insurance premiums on other government-backed loans is a good thing for borrowers. Yes, the monthly payments will be higher due to the MI payment but the borrowers didn’t have to come up with a 20% down payment and the annual premium can eventually be removed. It’s a trade-off, but one that borrowers who want to buy and finance a home with a low down payment, it’s a popular choice.

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