What Is FHA Mortgage Insurance?

FHA loans, insured by the Federal Housing Administration (FHA), are one of the most popular choices for people who want to buy a home or refinance an existing mortgage.

FHA loans require a very small down payment and have relatively relaxed guidelines for borrowers to qualify. But FHA loans aren’t the best choice for every borrower, in part because they require mortgage insurance, which adds an additional cost to the loan. Mortgage insurance is different from mortgage life insurance and the mortgage coverage that life insurance policies offer.

Mortgage insurance exists to protect lenders against losses they suffer when borrowers default. If a borrower defaults, the lender can foreclose on the loan and sell the home. The insurance covers all or part of the shortfall between the lender’s proceeds from the sale and the borrower’s unpaid loan amount.

Small down payment borrowers are perceived as being more likely to default since they have less equity at stake. That’s why lenders typically require mortgage insurance when a borrower makes a down payment that’s less than 20 percent of a home’s purchase price or appraised value.

Mortgage insurance is different from mortgage life insurance. Mortgage insurance, sometimes called mortgage default insurance, pays all or part of a lender’s loss when the borrower defaults. Mortgage life insurance pays off a loan when a borrower dies.

Although mortgage insurance protects the lender, the borrower pays for it. The benefit for the borrower is that mortgage insurance acts as an incentive for lenders to make loans to borrowers whose down payment is smaller than 20 percent — sometimes a lot smaller. The minimum down payment for a loan with FHA mortgage insurance is just 3.5 percent.

This example illustrates the benefit:

This lower upfront investment is especially helpful for first-time buyers who don’t have equity from the sale of their current home to use as a down payment for their next home.

FHA mortgage insurance involves two components: an upfront mortgage insurance premium (UFMIP) and an annual mortgage insurance premium (MIP).

The upfront premium is paid when the borrower gets the loan. The borrower doesn’t pay the fee immediately or in cash. Instead, the premium is added to the borrower's loan amount. The current FHA upfront premium is 1.75 percent of the loan amount.

The annual premium is divided by 12, and that amount is added to the borrower's monthly mortgage payment. This system means the borrower doesn’t have to pay the full amount all at once every year.

An individual borrower’s MIP can vary from less than $60 to several hundred dollars per month, depending on the borrower’s loan amount, loan term and down payment percentage. The borrower’s credit score doesn’t affect his or her MIP for FHA loans.

The monthly MIP calculation is complicated, so you should consult a mortgage professional for an FHA loan quote based on your situation.

The FHA has changed its MIP multiple times in recent years. Each time the FHA raised its MIP, FHA loans became more expensive for borrowers. Each increase also meant some prospective borrowers weren’t able to qualify for or afford the higher monthly mortgage payments due to the MIP.

In January 2015, the FHA reversed course and cut its MIP to 0.85 percent for new 30-year, fixed-rate loans with less than 5 percent down. The FHA projected that this decrease would save new FHA borrowers $900 per year, or $75 per month, on average. The actual savings for individual borrowers depends on the type of property they own or purchase, their loan term, loan amount and down payment percentage. As of 2019, FHA's mortgage insurance rates ranged from 0.8 percent to 1.05 percent, depending on the size of the loan and the amount of the down payment.

Changes in FHA’s MIP apply only to new loans. Borrowers who’ve closed their loans don’t need to worry that their MIP will get more expensive later.

First-time buyers sometimes assume that the FHA loan is always the best choice. That's true in some cases, but not all. Borrowers can find other home loans offering small down payments and in some cases cheaper mortgage insurance.

Conforming loans get their name because they meet or conform to Fannie Mae or Freddie Mac guidelines for the loan amount and the borrower's creditworthiness.

A benefit of employment in the U.S. armed services (plus a limited number of other federal agencies) is eligibility for a VA loan. VA loans do not require a down payment or monthly mortgage insurance.

The USDA offers several attractive loan programs. Most are limited to rural areas, and to people who have average or below-average income. If you live outside of an urban or suburban area, it pays to learn if you qualify for a USDA loan.

When the FHA increased its MIP in the mid-2000s, the FHA loan became a less attractive option. The January 2015 MIP reduction could make FHA-insured loans more competitive, but that still doesn’t mean the FHA loan will be the best or cheapest choice for every borrower.

Some low-down payment loans, other than the FHA loan, allow borrowers to cancel their mortgage insurance after they’ve built up a certain amount of equity in their home. Homeowners can build equity through mortgage repayment, value appreciation or both.

In some cases, borrowers must request mortgage insurance cancellation. In other cases, the lender is required to cancel the insurance. The cancellation rules can be complicated, but borrowers have an opportunity to get rid of mortgage insurance at some point. With an FHA loan, it is more difficult for borrowers to stop paying for mortgage insurance.

This restriction can make an FHA loan more expensive than the other options, especially if the borrower keeps the loan for many years. If the borrower sells the home or refinances within a few years, the MIP cancellation requirements are not as material.

Many borrowers choose an FHA loan despite the potentially higher cost of FHA mortgage insurance. One reason is that the FHA’s minimum down payment of just 3.5 percent is one of the smallest allowed on any type of loan.

While some conforming, VA and USDA loans also allow borrowers to make a very small down payment, these loans can be more selective than the FHA loan in terms of who can qualify.

Fannie Mae insures one type of loan that has a minimum down payment of 3 percent with PMI. This loan is available only to buyers who haven't owned a home during the previous three years and homeowners who want to refinance certain types of existing loans.

The VA loan allows borrowers to buy a home without a down payment. This loan is available only to U.S. military servicemembers, veterans and certain other borrowers. The FHA loan also offers low closing costs and easier credit qualifying guidelines, according to the FHA website.

Borrowers who have a moderately low credit score might be able to qualify for an FHA loan with a reasonable interest rate, while that same credit score might trigger a significantly higher interest rate for a non-FHA loan. Though the FHA mortgage insurance might be more expensive, the lower interest rate offsets some of that cost to the borrower.

Borrowers whose credit score is very low might be limited to the FHA loan for that reason alone. Most other types of loans have higher minimum required credit scores.

The bottom line is that home loans and mortgage insurance costs are complex and the comparison of an FHA loan to other loan options involves quite a few variables. The FHA loan might be the best choice for one borrower, but not another. The best way to figure out which loan makes sense for you is to talk with a mortgage professional about your personal situation and shop around so you can compare the costs of each loan.