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Why does my loan come with mortgage insurance?

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The law does not require lenders to have mortgage insurance, but nearly all lenders require it on their conventional mortgages. For the lenders, it's a win-win deal: they get protected against loss, and you have to pay the insurance premiums.

Lenders require mortgage insurance because they know that there is a high correlation between equity (the percentage of the house purchase price that the borrower has paid) and default. In other words, borrowers who make a large down payment are far more likely to continue making their mortgage payments.

Thus, most lenders require a down payment of twenty percent of the purchase price. Most borrowers, however, cannot easily pay a $20,000 down payment, for example, towards a $100,000 house. The answer to this dilemma is mortgage insurance. If you agree to mortgage insurance, the lender may reduce the required down payment to as little as three to five percent. The insurance company guarantees the remainder of the down payment and thus becomes a kind of hidden co-lender on your loan.

If you don't want to pay mortgage insurance, however, your first option is to scrounge up a down payment of twenty percent of your loan. Alternatively, you might consider:

• Accepting a higher interest rate. Interest payments, unlike insurance premiums, are tax deductible, but the interest rate on your loan will rise up to one percent, so it may end up costing you more than you save.
• Taking out a small second mortgage. This is the 80-10-10 strategy for buying a home; eighty percent of the price comes from your first mortgage, ten percent comes from your second mortgage, and ten percent comes from your down payment. Again, you save money on insurance premiums, but you'll have added closing costs, and your second mortgage will likely have a high interest rate.

On the other hand, if you do decide to accept mortgage insurance, you'll need to choose whether to pay the entire first year's premium at the closing (which saves some money) or absorb the insurance payments into your monthly house payments.

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