This is the second part in a five part series focused on giving buyers more information in one of the biggest decisions of their life. Click here for part one.
Protecting your biggest investment with insurance
For most homebuyers, insurance policy research sounds like a boring prospect. There are a few different types of insurance involved in the process of closing on a home, so we wanted to give a quick (and hopefully painless) break down of the different types of insurance and how they impact your home and your wallet.
Homeowners Insurance protects your house and possessions
As the residents of Houston slowly return back to their lives after Hurricane Harvey, the extensive damage done to homes in businesses is expected to have a major effect on the city’s vibrant housing market for some time. Only about 15% of residents in Harris County, where Houston is located, and only 28% of the homes in “high risk” areas for flooding were insured against floods.
As a result, many experts are predicting that those with little equity and extreme damage will simply walk away from their homes and mortgages. Without insurance, the cost of repairs will simply not be worth it.
While a basic homeowner’s insurance policy will cover a proletariat uprising or volcanic eruption, it doesn’t cover flooding or water damage. There are 8 types of insurance policies for homeowners and renters. The policies are peril specific, so each potential danger will be listed in the policy. Homebuyers need to be aware that common natural disasters like flooding and sinkholes are covered separately in specialized policies.
Another important takeaway for home buyers is to understand that even if the property they are interested in is not currently designated in a flood zone, it may still be in a high-risk area. The National Flood Insurance Program’s data that designates which areas as floods zones can be years or even decades out of date.
This doesn’t mean that every home should have flood insurance, but you may want to consider other factors and resources during your purchasing decision. You can always upgrade your policy after closing, but you can’t after a disaster hits, so be sure to understand the local threats to your potential property.
Title Insurance protects your property rights
In the video, ALTA Woman on the Street - What is Title Insurance, it’s clear that a lot of potential homebuyers and even current homeowners aren’t completely aware of what title insurance is and why an owner’s policy is paramount. Most people don’t have the ability to buy a house outright. That’s why the majority of buyers take out a mortgage loan. Until the mortgage is paid off, the homebuyers don’t technically own the home yet.
Title is the legal way of saying you own a right to a property. It may be partial or full interest in the property. Property rights can be thought of like a bundle of rights or sticks. You can divide your sticks as you please and rebundle them in order to transfer or sale your interest in the property to another individual.
Homeowners’ title insurance is important because the chain of title, how previous owners have divided their interests in the property, is not always clear and easy to discern. A title agent will search the public record of a property to determine if any encumbrances, like a tax lien or a construction lien, are on the property and make sure that any defect on the title is cleared before closing. They will also disclose any items that will remain against the property such as utilities and special assessments.
Mortgage lenders will require a title insurance policy to be issued on behalf of their interest in the property should you default on your home loan. The title company that issued the policy will reimburse the lender for any undetected defects that existed prior to the issuance of the title insurance.
For example, if there was a recorded lien on the property that was missed in the title search, the title insurance company will reimburse the insured for covered losses. If someone, like an heir of the previous owner, tries to sue for their rights, the insurance company will step in to fight the claim in court. Title insurance covers attorneys’ fees and court costs.
For a one-time premium, owners can be sure to have the same protection in their interest on the property as the lender. It makes sense to have the same protections as your bank.
Mortgage Insurance protects the lender
Mortgage protection insurance is designed to protect the lender should you lose your job or become disabled. Unlike Private Mortgage Insurance (PMI) or FHA Mortgage Insurance, it is totally voluntary. If you are young and healthy and have a stable job, have life insurance, or adequate savings, this type of insurance may not make sense for you.
PMI is required for a conventional loan unless the buyer is putting down 20% at closing. PMI will terminate automatically once the homeowner reaches 78% loan-to-value (LTV) according to the Homeowners Protection Act of 1998. The act also states that homeowners can request to cancel the PMI once they have 80% (LTV) or 20% equity in the home. The lender will not contact you; you must reach out to them in order to take advantage of this rule.
Typically, you pay for PMI both at closing and/or as a part of your monthly payment. It will increase your monthly payment and not go toward the principal of your loan. As a result, many buyers try to avoid a PMI by putting down 20%.
Depending on your credit score, loan term (30 year, 15 year, etc) and down payment percentage, PMI can range anywhere from .3% to 1.15% of your annual loan balance. That may not sound like a lot, but over 30 years, it can add up to thousands per year!
If you get an FHA loan, your mortgage insurance premiums are paid to the Federal Housing Administration instead of a private lender. The terms for paying off the mortgage insurance on a FHA loan are different from a conventional loan. As of June 3, 2013, if you put down less than 10% at closing, you will never be able to terminate the Mortgage Insurance Protection (MIP) with the FHA.
So, even though the FHA makes it easier for people with less money to close on a property, they will most likely end up paying way more for mortgage insurance than those who go through a private lender. Fortunately, there are no restrictions on refinancing out of FHA loans into a conventional loan with no PMI.
Spending a little extra time and effort in saving more for a down payment may be worth it. However, avoiding a PMI may not be possible for a buyer and owning versus renting may be a wiser investment. The best way to avoid a high PMI payment is to get multiple quotes from lenders.
Are you a betting buyer?
The nature of our world means that avoiding all risks is impossible. Insurance is meant to mitigate any potentials threats as much as possible and protect all parties that have a financial interest in a property. Even if you’re the gambling type, be sure to understand how each type of insurance affects you as a buyer and owner in order to make an educated bet. If you’re not sure what’s best for you, be sure to reach out to your real estate agent, title agent, or real estate attorney for more advice. Getting the right kind of insurance may be the difference between winning big or going bust.
Next up, we'll talk numbers... what are the closing costs and who pays for what?