What is mortgage insurance and how does it affect your down payment?

Many potential homebuyers balk at the thought of putting down 20% of a home's purchase price to secure a mortgage. The good news is that you can get a mortgage with a much smaller down payment — but you'll likely have to take on mortgage insurance as a result.

Mortgage insurance will reimburse your lender if you stop making mortgage payments, and is generally required on conventional loans (loans not backed by a government entity) where the down payment is less than 20% of the home's price.

Below, CNBC Select reviews what you need to know about mortgage insurance and how to factor it into the cost of owning a home.

Mortgage insurance is a type of insurance that protects a mortgage lender against a borrower not making payments. Unlike homeowners insurance, mortgage insurance mainly protects the lender and its investment in your home, not the borrower. However, the borrower is the one who pays the premiums.

Generally, this type of insurance applies in situations where the borrower is making a small down payment — for conventional mortgages, down payments smaller than 20% generally require private mortgage insurance.

Most mortgage insurance requires you to pay a monthly fee, and there may also be some costs added to your closing costs, or the fees you pay when you finalize your purchase or rolled into your mortgage.

Many mortgage lenders will work with homebuyers who make smaller down payments. For those who need flexibility with their down payment, Chase Bank offers mortgages with as little as 3% down, which is one reason it made CNBC Select's list of best mortgage lenders. PNC Bank also offers a variety of loan options, including a special one for medical professionals and a PNC Community Loan option that allows small down payments without private mortgage insurance.

There are two main types of mortgage insurance: private mortgage insurance (often known as PMI) and mortgage insurance payments (known as MIP). Here's what you need to know about the differences between the two types and how you pay for them.

What is private mortgage insurance?

Private mortgage insurance (PMI) is typically used for conventional mortgage loans. You usually pay a monthly cost for PMI, which can range from 0.1% to 2% of your loan balance per year.

There are four common types of private mortgage insurance you might come across:

• Borrower-paid mortgage insurance. The most common type of PMI has you pay an additional monthly fee with your mortgage payments, and you continue paying each month until it's canceled when you reach 22% equity in your home. In some cases, this insurance is removed with as low as 20% equity.
• Single-premium mortgage insurance. This private mortgage insurance is paid upfront. This leads to lower monthly payments, but it could mean forfeiting that money you paid upfront if you need to move and sell your home, or refinance your home.
• Lender-paid mortgage insurance. Your lender will pay your PMI with lender-paid mortgage insurance. However, these loans generally come with higher interest rates on the mortgage, so you'll still be on the hook for the costs.
• Split-premium mortgage insurance. Split-premium mortgage insurance has you pay a portion of your PMI costs upfront at closing, with the rest of the cost rolled into monthly payments.

What is a mortgage insurance premium?

Like PMI, a mortgage insurance premium (also known as MIP) is for borrowers using loans backed by the Federal Housing Administration (FHA) for their loans.

FHA loans may require as little as a 3.5% down payment. But MIP is required on all FHA loans, regardless of the down payment size. When you get an FHA loan, you'll pay an upfront mortgage insurance premium (which can be financed into your premium) and an annual premium payment as part of your mortgage.

Unlike PMI, which can be canceled when you reach a certain amount of equity in your home, MIP requires you to refinance your mortgage to a conventional mortgage before you can get rid of it. If you made a down payment of 10% or more with an FHA loan, you'll pay MIP for 11 years. Without a 10% down payment, you'll pay MIP for the life of the loan.

Private mortgage insurance costs can range from 0.1% to 2% of your loan balance per year.

MIP costs are generally 1.75% of the loan amount upfront, with annual payments between 0.15% and 0.75% of the loan balance amount each year.

There are several things to consider before deciding if paying for mortgage insurance is the right move for you. When you're ready to buy a home, you'll want to consider the pros and cons carefully.

Pros of mortgage insurance

PMI or MIP could be helpful in some situations. Consider these pros:

• You could be a homeowner sooner. By paying PMI or MIP, you may not have to wait to save as much money to buy your home.
• You might have more cash to spend elsewhere. The money that would have gone toward a full 20% down payment can now be used on home renovations or other expenses.

Cons of mortgage insurance

Mortgage insurance could also work against you as you buy a home. Here are the cons to think about:

• You'll have higher monthly payments. With MIP and some types of PMI, you'll also add to the monthly payment on your mortgage.
• You could carry it for years. You can possibly cancel PMI after you reach 20% equity, though it won't automatically cancel until you reach 22%. With MIP, you may need to pay for 11 years or the whole life of the loan, depending on the size of your down payment. It is possible to cancel MIP by refinancing your mortgage to a conventional mortgage.

Mortgage insurance can go away, though it might take some effort. PMI can be eliminated in four ways:

• Wait for your home's equity to reach 22% for automatic cancellation. PMI must be canceled by the loan servicer when you reach 22% of your home's equity.
• Request your loan servicer to cancel PMI once your home equity has reached 20%. You'll typically need to have a good payment history, not be behind on your payments, and not have a second mortgage like a home equity loan or line of credit.
• Get your home reappraised. If home values near you have risen substantially or you've made big improvements, you may have more equity in your home than you would otherwise. According to the National Association of Realtors, the typical home appraisal costs between $300 and $400.
• Refinance your mortgage. If you have an FHA loan and want to get rid of MIP (while also having enough equity in your home to avoid PMI), you could lower your monthly payment by refinancing. Just consider the pros and cons of refinancing your home before going with this option, as it could mean paying another set of closing costs, taking on more debt, and lowering your credit score.

Mortgage insurance can either be private mortgage insurance or a mortgage insurance premium (MIP), depending on your loan type. While having mortgage insurance helps you secure a loan with a smaller down payment, it will add to your monthly payments and/or to your closing costs.

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