Mortgage Insurance vs. Homeowners Insurance: 5 Differences to Know About

Photo: istockphoto.com

When you’re buying a house, the sticker price on the home itself is only the beginning of what you’ll pay. Closing costs, fees, interest, and various forms of insurance will all tack extra dollars onto your monthly payment and can make it tricky to establish how much you can really afford to spend. Insurance, by definition, is designed to protect from financial harm. The policyholder pays a premium in exchange for financial coverage in the event of a loss that the policy indicates is covered. There are several different kinds of insurance available when purchasing a home, and the differences between them can be difficult to parse. Homeowners insurance and mortgage insurance may both be required by your lender, but why? What do they do? How are they different? You may have questions, such as “Is my homeowners insurance included in my mortgage?” and “Can I cancel my private mortgage insurance at some point?” At a time when you’re spending more money than you thought possible, it can be helpful to really understand what you’re paying for and why it’s necessary (or required) as you line up the costs of your home purchase and begin to budget for your monthly payments.

1. Private mortgage insurance (PMI) covers the lender, whereas homeowners insurance covers the borrower.

Photo: istockphoto.com

The mortgage insurance definition describes a policy that insures the amount you borrowed for your mortgage—but it isn’t protecting you, it’s protecting your lender. Lenders take an educated chance on every borrower they lend to: after assessing the borrower’s credit history, debt-to-income ratio, and other financial factors, the lender decides how likely the borrower is to be able to pay back the loan and sets the interest rate accordingly. Should the borrower be unable to make their payments, the lender can foreclose on the house, taking back the property and selling it to someone else to recoup its financial loss.

Sometimes, though, the lender takes a bigger chance. If the borrower doesn’t have a sizable down payment to make on their loan, the lender is at greater risk, as the cost of the foreclosure and the sale may exceed the amount of value in the home and result in a financial loss to the lender. As a result, borrowers who are making a down payment of less than 20 percent of the cost of the home may be required to purchase private mortgage insurance, or PMI. If the borrower defaults on the loan, the PMI company will pay the lender for any losses it incurs during the foreclosure and sale of the home. The lender takes a chance on a borrower, and the borrower pays for insurance that protects the lender. Do you have to have mortgage insurance? If your lender says you do, then yes. It’s certainly possible to shop for other lenders who may have different policies, but if your lender demands that you carry mortgage insurance, it will be a condition of approving the loan and not subject to negotiation.

Homeowners insurance, on the other hand, protects the borrower. Buying a home is the most significant investment most people will ever make, so when you sign your mortgage papers, you’re signing up for many years of repayment. But what happens if a disaster befalls your home? If a fire sweeps through the home and destroys it, or a tornado levels the home to the ground, you will still owe the balance of your mortgage even though you no longer have a house. Homeowners insurance protects borrowers from this devastating financial burden: In the case of a weather event, fire, accident, or vandalism, the homeowners insurance policy will cover the cost of repairs or replacement of the home. The borrower will continue to make mortgage payments, but the home itself will be restored by the homeowners insurance policy once the deductible has been met. In addition, homeowners insurance will cover the cost of living elsewhere while repairs or rebuilding is taking place, preventing the high cost of renting or staying in a hotel during this time from causing additional hardship. Homeowners insurance will also protect borrowers from smaller events that can cause financial difficulty. If a pipe bursts, for example, the homeowners insurance policy won’t cover the repair of the pipe, but it will cover the damage caused by the leaking water. A home warranty, if you have one, will cover the cost of repairing the pipe itself. Homeowners insurance does not cover maintenance or repair problems due to age or wear and tear. This kind of event may seem small, but the cost of cleaning up damage can be significant. Homeowners insurance is designed to protect the borrower from losing their home (or the use of it) and still having a mortgage to repay.

Sometimes in mortgage documents, lenders will refer to hazard insurance as opposed to homeowners insurance, further complicating the vocabulary of the closing. Hazard insurance is one component of a full homeowners insurance policy that focuses on the structure of the home itself rather than the grounds, outbuildings, or liability. When comparing hazard insurance vs. mortgage insurance, however, hazard and homeowners insurance can be considered the same thing.

2. Private mortgage insurance is often required by the lender in the event you default on your loan. Homeowners insurance is required by all lenders for all borrowers.

Is home insurance included in mortgage documents? It is standard procedure for all lenders to require all borrowers to carry homeowners insurance policies for the duration of the mortgage, and yes, this will be included in the commitment you make when you sign your mortgage documents. This includes refinanced mortgages and all federal and local mortgage programs as well. The simple fact is that homeowners insurance allows borrowers in tight financial situations to make prompt repairs when the home is damaged, which maintains the value in the home. As the home itself is the collateral for the mortgage, homeowners insurance makes it possible for borrowers to stay on top of necessary repairs following a covered event and makes it easier for borrowers to keep the house in good condition.

PMI requirements will vary somewhat by lender, although it’s a standard requirement if a borrower has a down payment of less than 20 percent. In some cases, a lender may require PMI even with a 20 percent down payment if the borrower has a poor credit history or a high debt-to-income ratio—or a lender may choose not to require PMI with a down payment of slightly less than 20 percent. In most cases, borrowers can request that PMI be canceled by the lender once their equity has reached 20 percent, but the conditions are up to the lender and will be included in the original mortgage documents. Some federal programs, such as the FHA loan program, include a built-in requirement for a form of mortgage insurance called Mortgage Insurance Premiums, which are applied to all FHA loans and continue for the duration of the loan. Regardless, borrowers will never need to ask themselves “Do I need mortgage insurance?” because this is not a decision the borrower gets to make: PMI is the lender’s call.

Photo: istockphoto.com

3. PMI and homeowners insurance cover different assets and interests.

PMI is, quite simply, insurance on mortgage loans. If you default on your payments, the PMI will pay a sum to the lender to cover its losses after it processes and sells your home through foreclosure. It protects the lender from loss—though it does give borrowers a leg up as well, because prior to the advent of PMI many borrowers who couldn’t scratch up a 20 percent down payment most likely would have been denied a mortgage loan. So while PMI protects the lender, it also opens doors for some borrowers.

Homeowners insurance covers a wide swath of assets. These policies are usually policies of exclusion, meaning that unless an event is specifically excluded in the policy, it’s covered. Fires, theft and vandalism, and natural disasters such as hurricanes, tornadoes, and snowstorms are usually covered. Unfortunately, floods are not usually covered, even if they are caused by covered events, so if you live in a flood-prone area you’ll want to consider purchasing additional flood coverage to add on to the policy. Earthquakes are also excluded. Homeowners insurance does cover the cleanup following a system or appliance failure, such as mold damage, water damage, or fire damage, but it will not pay for repairs to items that have suffered from age or normal wear and tear. If you’re forced to live elsewhere during repairs to your home, a homeowners policy will cover your lodging and some of the extra services you may need because you’re not living in your home.

In addition, homeowners insurance policies protect the homeowner from liability: If a guest or neighbor is injured on the property, homeowners insurance will cover the medical bills and the cost or payout of any legal action that follows. If a homeowner or their family causes damage to someone else, even while not at home, the homeowners policy will cover the damage that you caused and your liability for it. Some policies will even cover identity theft damages and credit repair.

4. Homeowners insurance is not necessarily included in the mortgage you pay on the monthly basis. PMI is paid in monthly installments to the lender or insurer.

Is homeowners insurance included in mortgage contracts? Well, yes and no. All lenders will require that their borrowers carry homeowners insurance, so acknowledgment of that requirement is something you’ll have to sign when you close on your mortgage. How you choose to acquire that insurance and pay for it, on the other hand, is up to you. You can choose the company from whom you purchase your homeowners insurance—and homeowners are advised to shop around carefully because quite a lot of money can be saved by bundling homeowners insurance and auto insurance. While some mortgage lenders will allow you to pay the homeowners insurance company directly as long as you provide proof that your policy is in good standing, others lenders will require that you pay through an escrow account that they hold. A portion of your monthly mortgage payment goes into that escrow account, and then the lender will pay your homeowners insurance premium from the account when it is due. You are still free to choose the insurance company and change it at any time, but the lender will make sure that the payment is made and the policy remains in good standing.

PMI is handled differently. Some lenders will offer you a choice between making an annual payment or adding an amount to each month’s mortgage payment, while others will make the decision for you. FHA loans process MIP differently, requiring an up-front premium of approximately 1.75 percent of the loan amount at the time the loan is disbursed (which can usually be rolled into the closing costs) plus an annual fee of 0.45 to 1.05 percent of the loan amount, which is spread out over each year’s monthly payments.

Photo: istockphoto.com

5. Even once you pay off your mortgage, it’s in your best interest to continue paying for homeowners insurance.

If you choose, you can cancel your homeowners insurance once you’ve paid off your mortgage. However, just because you own property outright doesn’t mean you don’t need to protect it. Once it belongs to you, your home and land are some of your greatest assets, and if you don’t carry a homeowners insurance policy and disaster strikes, you’ll find yourself in a position where you have nothing to sell and no fallback: All the money you paid toward the house will be lost. In addition, your homeowners insurance provides you with liability coverage, so you’ll lose that as well. You do need homeowners insurance, mortgage or not.

Is house insurance cheaper without a mortgage? It can be. Some mortgage lenders stipulate in their requirements that the deductible carried on the required homeowners policy be set at a specific level. This level is usually quite low because the lender doesn’t want a high deductible to keep borrowers from completing necessary repairs after a covered event. Once freed from the requirements of your lender, however, you’re welcome to choose as high a deductible as you’d like. If you have enough savings to cover a higher deductible should the need arise, you can save substantially on your premium by choosing a higher deductible. Similarly, mortgage lenders may state requirements for the level of coverage you carry, which can ramp up prices. Once you’ve paid off the mortgage, you can choose lower total coverage and plan to pay for any remaining costs out of pocket, should you decide to. This will also lower your premiums. So while you won’t get a formal discount for buying a homeowners policy without a mortgage, the freedom to select the options and coverage level you prefer may allow you to save money overall.