# How Your Loan-to-Value Ratio Affects Mortgage Insurance

Published on December 21, 2016

## What is Loan-To-Value Ratio (LTV)?

Loan-to-value ratio, or LTV ratio, plays a big part in determining your home affordability. Calculating your loan-to-value ratio is simple: it’s the loan amount divided by the property value. Check out our LTV calculator below.

LTV Calculator:

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## So what is a good Loan-To-Value Ratio?

This ratio is important to the lender because it’s used as a way to measure their risk. Let’s compare two scenarios to see why this is important.

Consider a borrower who puts 20% down on a \$200,000 home. The borrower puts down \$40,000 and the lender puts up the other \$160,000 to complete the home purchase.

Now, let’s pretend some unfortunate things happen. Say, the home needs a new roof, and the homeowner decides not to repair it. Even worse, the homeowner decides to stop maintaining the rest of the property (like the front yard).

The lender can rest assured that even in a bad scenario, where the home value goes down 10% due to its need for a new roof and the loss of curb appeal, the home could be sold for \$180,000. They would recoup their home loan amount, and the borrower would receive \$20,000 of their investment back. Here the borrower shoulders most of the loss, but their loss was a result of their decision (or inability) to maintain their home.

From the lender’s perspective, the borrower should be incentivized to maintain the property so they can protect their investment.

Take that same scenario, but now let’s assume the borrower only puts down 5% of the purchase price, or \$10,000, and the lender puts \$190,000 in to the transaction.

Say the borrower fails to make that critical repair and doesn’t maintain the property. The home value drops to \$180,000, and suddenly the home is worth less than the loan amount. If the borrower were to sell the home, it would actually cost them money. They would have to pay the extra \$10,000 to pay off the loan. When this happens, a home is what’s called “underwater.” The borrower has lost their entire investment, and the lender has now lost \$10,000 as well.

As you can see, a loan with a higher loan-to-value ratio is riskier for both the borrower and the lender. A conventional loan requires a 20% down payment, which lenders and government agencies are comfortable with. But what if you don’t have a 20% down payment?

## How does PMI work?

If a borrower puts less than 20% down, the loan will require mortgage insurance. This is often referred to as mortgage insurance (MI), private mortgage insurance (PMI), or sometimes as a mortgage insurance premium (MIP).

Mortgage insurance protects the lender’s investment over the 80% loan-to-value mark and is generally paid for by the borrower. In our scenario above where the lender had a \$190,000 loan and the property sold for \$180,000, the mortgage insurance company would have paid the lender for their \$10,000 loss.

Mortgage insurance works differently based on the type of loan, the agency backing the loan, and the overall loan amount. It can present itself in two ways: upfront premiums and monthly premiums.

There are a number of loan products that allow for a lower down payment with varying types of mortgage insurance requirements.

• <0% down> – This is a rare case, usually reserved for military veterans getting a VA loan, or buyers who qualify for assistance programs. In the case of VA loans, the borrower is not required to pay a monthly mortgage insurance premium, which is an excellent way we collectively thank someone for their service.
• 3% – 9.9% down – These are much more common, with the FHA, Fannie Mae and Freddie Mac all offering loan products in this tier. These agency loans will require mortgage insurance.
• 10% – 19% down – Fannie, Freddie, and FHA all offer 90% LTV products. Again, these agency loans require mortgage insurance.
• 20%+ down – With this high of a down payment, you are eligible for conventional loans offered by Fannie, Freddie, and most major banks, which do not require mortgage insurance.

So what does mortgage insurance cost? For Fannie and Freddie products, they partner with outside companies who insure the loans, so there is no set rate. In our Radian’s borrower-paid MI rates to estimate your mortgage insurance costs.

FHA loans operate according to a grid. You can follow the link to estimate what your mortgage insurance payments would be.

## Upfront vs. Monthly Mortgage Insurance

There is a key distinction between conventional loans (offered by Fannie and Freddie) and FHA loans. FHA loans require both an upfront fee and an annual fee for mortgage insurance. The upfront fee for FHA loans is a hefty 1.75% of the loan amount. The annual premiums range from 45 to 105 basis points.

For conventional loans, there is no upfront fee for mortgage insurance, which translates to a significant savings in closing costs.

Another key point to note is the ability to remove mortgage insurance. For conventional loans, if you elect to pay the mortgage insurance monthly, the insurance premium is removed once you reach a loan-to-value ratio of 78%. When that happens, your monthly payment will be lowered accordingly. (Nice!)

With FHA loans, it’s slightly more complicated. Depending on your loan amount, LTV, and loan term, you will either pay the mortgage insurance for 11 years, or for the life of the loan. Read more about FHA loans.

## Borrower-Paid vs. Lender-Paid Mortgage Insurance

There are two ways you can pay your monthly mortgage insurance premiums. You can pay for them directly, or you can have the lender pay for them on your behalf.

Borrower-Paid MI – You will have a separate line item for the mortgage insurance premium every month, which is paid in addition to your monthly mortgage payment.

Lender-Paid MI – Similar to a no-cost loan, the lender will increase your interest rate slightly, and they will use the higher cost of the loan to pay the monthly mortgage insurance premiums. In this case, there is not a separate line item for mortgage insurance.

Borrower-paid MI often costs more out of pocket each month. But on the plus side, once the loan reaches a certain loan-to-value ratio (78%), the premium may be removed if all other requirements are fulfilled (e.g., no late payments). You receive the best available interest rate, and you only have a monthly mortgage insurance payment until requirements are met to remove it.

Broadly speaking, in respect to monthly cash flow, lender-paid MI is generally more favorable to the customer. It generally requires a lower monthly payment than borrower-paid MI. Also, lender-paid MI turns mortgage insurance into an interest expense, which can be deducted on your tax return. The downside is you will pay the premium for the life of the loan. Unlike borrower-paid MI, lender-paid MI cannot be removed.

Before choosing between these two options, we recommend consulting your loan officer as well as a certified tax professional.

## Summary: Mortgage Insurance

The upside of mortgage insurance: Having 20% for a down payment is a pretty big barrier for most people. For many, having the ability to purchase with a lower down payment more than makes up for the cost of mortgage insurance premiums.

The downside: Aside from the obvious point that it is an added cost, this mortgage insurance premium is factored into your DTI ratio when lenders calculate your affordability.

The up-front premium can be rolled into your loan, eliminating the need to pay cash up-front. But the monthly premium can significantly lower your maximum purchase price, which you need to take into account while shopping.

If you have more questions about your loan-to-value ratio or our LTV calculator, chat with one of our licensed Loan Specialists. If you’re ready to see what you might be able to qualify for, get your personalized rate quote in 3 minutes.

Steven Fung is a licensed Loan Specialist at Clara with over 17 years of experience. When he doesn’t have his mortgage hat on, he enjoys repairing old cars and working on home improvement projects.
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