Mortgage Insurance vs. Home Insurance

One of the easiest mistakes to make as a first-time homeowner is getting “homeowners insurance” and “mortgage insurance” confused. On the surface, these two types of insurance appear similar and, due to their names, often conflated or confused with one another. But they’re not the same, as one covers the homeowner, the other the lender.

While different, these insurances are an equally important, necessary aspect of the home-buying process. To help clear up this confusion, we’ve created this guide detailing what mortgage and homeowner insurance are, how they work, and the differences between them.

Mortgage Insurance Vs. Homeowners Insurance

The easiest way to understand the difference between mortgage and homeowners insurance is to look at what they cover. Homeowners insurance, or hazard insurance, protects homeowners in the event of theft or a natural disaster. On the most basic level, it insures the home, structures, and possessions therein. In the event of theft or a disaster, homeowners insurance provides funds to repair or replace what has been lost. Mortgage insurance, or private mortgage insurance (PMI), insures a mortgage loan against default. If a homeowner fails to pay their mortgage, PMI will protect the lender and its investment.

What is Mortgage Insurance?

Mortgage insurance, or PMI, is insurance some homeowners must take out when applying for standard home loans. PMI does not protect you, your home, or your possessions. Instead, it only protects the lender.

Is Mortgage Insurance Required?

PMI is required when the mortgage lender feels the borrower is a potential risk for future defaults. Lenders typically consider any homeowner who cannot afford a down payment of 20% of the home’s purchase price to be high risk, requiring them to pay PMI. PMI may also be required if you refinance your home while your equity is less than 20%.

Unfortunately, a 20% down payment is a large obstacle that most homeowners can’t overcome, meaning most Americans have to pay PMI. In the last quarter of 2021, the national median home cost was around $423,000, meaning that down payments to avoid PMI were around $84,000.

How Expensive Is Mortgage Insurance?

The average cost of PMI is between 0.5% to 2.0% of the total cost of your mortgage loan per year. The average home costs $470,000, and as a result, yearly PMI costs are between $2,350 and $9,400. This amount can be paid either monthly or as a lump sum at the beginning of the year. Most mortgage companies roll your PMI payments and property taxes into your monthly payments through an escrow account.

How Long Do You Have to Pay PMI?

For conventional loans, you’ll have to pay PMI until you reach a mortgage balance of 80%, meaning your home equity reaches 20%. At this point, you may request a PMI cancellation. If you don’t request your PMI to be canceled, the mortgage company must automatically cancel it once your balance reaches 78%. Both conditions depend on paying your PMI on time and being in good standing with your lending company. Furthermore, your lender must cancel your PMI once the loan reaches its halfway point. For example, if you have a 20-year loan, once it reaches the 10-year point, your lending company must cancel it.

Are There Ways to Avoid Paying PMI?

While paying PMI is a standard part of many mortgages, there are some ways to avoid paying it:

Have a 20% down payment: As stated above, the easiest way to avoid paying a PMI is by putting 20% down on your loan. Unfortunately, with the high cost of mortgages, rising interest rates, and increasing inflation, this is becoming more difficult for homeowners.

Go with a Lender Paid Mortgage Insurance loan: Also known as an LPMI, these are loans in which the lender covers the cost of PMI. The lender will pay the PMI in these loans but increase the interest rate to compensate. These loans can be a mixed bag, and in some cases, you can save in the long run, while in others, the interest rate hike winds up costing more than the PMI. 

Apply for a VA Loan: Veterans Association (VA) loans are backed by the United States Government and don’t require PMI or a down payment. However, these loans carry a one-time funding fee ranging from 0.5% to 3.6% of the total loan amount. Only veterans, military service members, or spouses of veterans are eligible for these loans. Check out the U.S. Government Department of Veterans Affairs website to learn more about VA loans.

Apply for a USDA Loan: United States Department of Agriculture (USDA) loans, technically, don’t have PMI, but they have a “funding fee.” Like VA loans, USDA loans are backed by the U.S. Government. This system allows USDA loans to have lower down payment requirements and no PMI. But, you’ll have to pay a two-part fee to the government for it to cover the loan. The first part is an upfront, lump sum payment equal to 1.0% of the total loan amount. Then you’ll have to pay an annual fee, billed as a part of your monthly mortgage payment, equal to 0.35% of the total loan amount. FHA loans have a similar system called mortgage insurance premium (MIP), in which the borrower pays for the loan’s lifetime.

Take out a piggyback loan: A piggyback loan, also called an “80-10-10” or “combination loan,” is a type of loan created to avoid PMI. In these loans, the homeowner takes out a second mortgage worth 10% of the home’s total value. This second mortgage, combined with a 10% down payment, drops the primary loan to 80%, avoiding the PMI. This loan gets its name because the smaller loan “piggybacks” onto the larger loan. 

What is Homeowners Insurance?

Homeowners insurance protects you from financial loss if your home, surrounding structures (depending on the policy), and possessions are damaged from natural hazards or lost due to theft. Homeowners insurance creates an invaluable monetary safety net that allows you to recoup your losses in the event of a catastrophe.

Is Homeowners Insurance Required?

Most mortgages require homeowners insurance as a part of the home purchase. Once your mortgage is paid off, you no longer have to carry homeowners insurance. However, if you’re no longer required to carry homeowners insurance, it’s highly recommended you continue to use it. Homeowners insurance is designed to protect the homeowner and can help you recover in the event of a disaster.

How Expensive is Homeowners Insurance?

Home insurance companies use complex systems, typically through underwriting software and proprietary calculators, to determine each policy’s cost, deductibles, and payouts. No two companies’ systems are the same, and each policy is calculated on a case-by-case basis. Because of these factors, policies can vary wildly from one to another and from company to company. Generally, companies consider the following when determining your home insurance policy:

• Replacement cost based upon the value of your home
• Your home’s location
• Your home’s age
• Your home’s size (in square footage)
• Attractive nuisances
• Construction information
• The number of inhabitants
• Public Protection Classification (PPC)
• History of housing damage in that area
• The crime rate of the area
• The client’s claim history
• Pets
• Client credit score

The national average for homeowners policies ranges from $1,200 to $3,000 per year. Currently, homeowners insurance policy costs are rising due to inflation. This year, consumers reported that their policies have increased by as much as 15% to 20%, or about twice the inflation rate for their respective states.

What Does Homeowners Insurance Cover?

The types of coverage in your policy will vary from company to company, but most homeowners insurance coverage includes the following:

• Personal property coverage: Also called dwelling coverage, this protects the structure of your home.
• Personal belonging coverage: this protects your possessions
• Personal liability: This protects you in the event of accidents or injuries on your property.
• Additional living expenses: This provides funds for housing, food, and travel in the case of displacement due to a disaster.

Your policy will protect you from some of the most common types of damage (referred to as “perils” in policies) your home can encounter. Some of the most common types of perils covered by policies include:

• Fire damage
• Weather damage, such as:
  • Lightning
  • Wind 
  • Hail 
  • Snow weight damage
  • Freezing of systems, such as pipes or utility lines
• Explosions
• Vandalism or riots
• Theft
• Damage from power surges
• Falling objects or flying debris
• Flooding from internal systems or appliances
• Various faults or failures of fire protection, air conditioning, hot water, or steam systems
• Damage from vehicles or aircraft

While policies cover a wide range of perils, many events and types of damage are excluded. You’ll have to purchase separate, specific policies or opt-in for additional coverage for these types of incidents. Commonly excluded perils include:

• Flooding from natural events, such as extreme weather
• Water damage from drain failure
• Earth movement or shifting, such as earthquakes or landslides
• Pest infestations
• General wear and tear
• Power or utility failure
• Military events, such as acts of war

Closing Thoughts

While their names are similar, homeowners insurance and mortgage insurance are two completely different policies. Homeowners insurance provides financial protection for new homes in the event of disasters or theft, while mortgage insurance protects the lender from default. However, both are required when applying for most mortgages and home loans. Understanding the differences between these two invaluable insurances is a key part of homeownership.

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