What is mortgage insurance for?

Lenders, over many years of lending, find that the process of foreclosing to obtain title to a home is quite expensive (loss of value, vandalism risk, insurance, attorney costs, resale costs, etc). They generally do not recapture all of their money unless the house was originally worth A LOT more than the loan. If there is not a significant equity cushion in the property (that is, the balance of the loan exceeds 80% of the value of the property), they are unable to recapture enough funds to be made whole. Read: They lose a lot of money.

(Recently, it should be noted, lenders are still losing their shirts even when the original equity cushion was 30-40%+, but averaged over time, that has not been the case).

Lenders obtain insurance from third party private or government insurance companies so that their liability is limted to 80% of the value of the property at the time of the loan. The borrower pays this insurance – allowing the lender to lend with less than 20% equity (down payment) at terms similar to what would be offered if the equity (or down payment) was available – without the extra risk that would make this a poor business decision.

Oversimplified – lets say you are buying a $100,000 house. You are putting down $10,000 (10%), so the lender must lend 90%. The lender would rather only lend 80% (80,000) to feel safe about the investment, so in order to increase the loan to $90,000 the lender obtains an insurance policy (usually paid by the borrower, but sometimes paid by the lender) that will pay out the additional $10,000 (the addtional 10%) in the case that your loan becomes delinquent, and/or the lender must foreclose and resell the property to get the money back.

This insurance can be paid all at once a the beginning of the loan and/or monthly while the loan principal is being paid down – or can be paid indirectly in the form of a higher rate to the lender over the life of the loan. When the loan principal hits 78% of the value of the house, borrower paid mortgage insurance is cancelled (by law), and the borrower is no longer obligated to maintain the extra insurance payments.