Consumers who have purchased a home recently with a down payment of less than 20% of the purchase price have most likely been required to obtain mortgage insurance. For most home buyers, the entire concept of mortgage insurance is both confusing and expensive. Armed with knowledge of the mortgage insurance system, however, consumers can use mortgage insurance to their benefit and save money in the long run. Mortgage insurance (also known as private mortgage insurance, PMI or MI) protects lenders against a loss if a borrower defaults. In the past, mortgage lenders were not permitted to make home loans without the borrower providing at least a 20% down payment. The risk was perceived as too great in case the borrower defaulted. As demonstrated in the 1980's, even 20% equity in a property can disappear quickly during market downturns. With the introduction of mortgage insurance, mortgage lenders were permitted by federal agencies to make loans as high as 97% of the value of a property. The mortgage insurance company protects the lender against some but not all of the loss in the event of a default. It is important to note what mortgage insurance is not. Many people mistake private mortgage insurance for mortgage credit life insurance. Mortgage credit life insurance is a term life insurance policy that will pay off a borrower's mortgage payment in the event of the borrower's death. Private mortgage insurance has nothing to do with this type of coverage. Many home buyers consider mortgage insurance a hindrance to home ownership. In fact, the reverse is true. Without mortgage insurance, most lenders would simply require higher down payments of 20% or more. Since saving for a down payment represents one of the largest obstacles to buying a home, mortgage insurance plays an important role in the home buying process. Mortgage insurance costs vary with the percentage of down payment, the loan amount, and the type of loan selected. Lower down payments and higher loan amounts increase the cost of premiums. In addition, adjustable rate loan products will result in higher premiums than fixed rate mortgage loans. While the factors cited above affect mortgage insurance costs for a borrower, there is little variation in costs from insurance company to insurance company. Pricing among competitors is nearly identical. While mortgage insurance companies differ little in cost, they do vary widely in terms of their willingness to approve a low down payment loan. All loans that require mortgage insurance must be approved by the mortgage lender and the mortgage insurance company. Home buyers who are rejected for a mortgage loan by a lender that blames a mortgage insurance underwriter should ask that lender to submit the loan to other mortgage insurance companies. One major change in the mortgage insurance industry over the last several years has been the introduction of monthly mortgage insurance premiums. Five years ago, a borrower requiring mortgage insurance was required to prepay the entire year's premium for mortgage insurance at closing. A policy that cost $60 per month would mean that closing costs would rise by $60 times 12 months, or $720. Today, mortgage insurance companies all offer monthly premiums that essentially finance the up-front charge over time. That same $60 payment, for example, would today be about $63 per month but $720 would be saved at closing. Once borrowers use a mortgage insurance program to purchase a home, their first reaction is usually to try to determine how long before they can cancel the coverage and stop the monthly mortgage insurance payment. Most mortgage insurance policies require that the coverage remain in effect on the loan for a minimum of two years. After that period, the borrower can request cancellation of the policy as soon as the equity in the property is 20% of the value or greater. The increase in equity can be created by paying down the mortgage loan balance, improving the property, or through improved market values. In any case, borrowers must pay for an appraisal that must be submitted to the mortgage servicing department. Most states now require that mortgage lenders cancel a mortgage insurance policy once their is 20% equity in a borrower's property. The burden to initiate the cancellation of coverage is on the borrower. Sometimes, despite state regulations, lenders will refuse to cancel coverage. They can dispute the quality of the appraisal and delay cancellation, for example. As a last resort, borrowers can always refinance with another lender when they are sure that they have sufficient equity in the property. As an alternative to mortgage insurance, some lenders now offer low down payment loans with no mortgage insurance. These loans come with higher interest rates that essentially include the cost of the mortgage insurance premium in the mortgage interest payment. The benefits to these programs are that the loan does not need to be approved by a mortgage insurance company and the higher interest payments are tax deductible (mortgage insurance payments are not tax deductible). The drawback to these programs is that, unlike mortgage insurance, the higher interest rate can never be canceled. Borrowers with high tax burdens should consider comparing both programs with their tax advisor. A relatively recent phenomenon has been a request by borrowers to put as little down payment as possible and get mortgage insurance. With cash invested in mutual funds yielding 10% to 15% and home values relatively stable, borrowers reason that they will earn more from their investments than the cost of mortgage insurance and higher mortgage interest payments will cost them. As always, borrowers should carefully weigh their mortgage insurance options and programs with a mortgage professional when buying a home with a low down payment. Michael Licamele is the Editor of MortgageAlmanac.com and President of Residential Finance Network at rfnc.com. |
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