The best way to explain it is with an example. Let’s assume that you get a mortgage and that you never pay your loan back and it ends up in foreclosure. Let’s also assume that you owe $200,000 on that mortgage; however, the bank that foreclosed on your property is only able to sell it for $180,000. The mortgage insurance will kick-in to cover the remaining amount, in this case $20,000, of the balance due.
It is usually required when you put down less than 20 percent on the purchase of the mortgage. It is also required when you have less than a 20 percent equity position in the house.
One of the ways to get around mortgage insurance is to split up the mortgages with a first mortgage and a second mortgage. Sometimes we recommend it; sometimes we don’t.
Second mortgages are usually tied to the prime rate, and if the prime rate is high, you may be better off taking the mortgage insurance. If the prime rate is low, then you are probably better off getting a first and a second mortgage and keeping the first mortgage at a maximum loan-to-value of 80 percent. This is a good strategy, when the prime rate is low because second mortgages and home equity lines of credit are usually tied to prime.
When the prime rate is high, it may not be the best strategy. If you compare the cost of your first mortgage payment plus your second mortgage payment with the cost of a first mortgage that has mortgage insurance and the prime rate is high, you may end up with a larger payment and be better off taking the mortgage insurance or doing what is called ‘lender paid mortgage insurance.’ In this case, the lender increases your rate by approximately 3/8 percent. Paying an extra 3/8 percent to avoid mortgage insurance is not a bad way to go in certain cases. But if the prime rate is low enough, splitting your mortgage into a first and a second mortgage is usually a good option.