Saving on Mortgage Insurance

by Kirk Hagert

Any consumer putting less than 20% down to buy a home must take the time to learn about private mortgage insurance. While most Americans have a unique love-hate relationship with insurance, few understand mortgage insurance. Actually, many people in the mortgage and real estate industry are in the dark when it comes to mortgage insurance (MI, also known as PMI).

MI is required on most loans exceeding an 80% loan to value (i.e. with less than a 20% down payment). It protects a lender against borrower default. Although the borrower pays the cost of the insurance, a claim would be paid to the lender if the borrower stopped making mortgage payments. MI is not to be confused with mortgage life insurance, which pays a beneficiary in the event of a borrower's death.

Generally, the investor or secondary market agency that ends up with a mortgage loan (such as Fannie Mae and Freddie Mac) will require MI. It has long been known that the incidence of borrower defaults increases as the loan-to-value (LTV) increases. The less money a borrower has invested in a home, the more likely he or she is to walk away from that obligation in times of financial distress. There are a number of other factors that directly influence or determine a borrower's ability and willingness to repay an obligation, including the collateral (or integrity of the home itself), the type of mortgage loan (e.g. fixed or adjustable), and most importantly, credit history or a lack thereof. Many other factors enter into the final underwriting decision.

One fact is certain: without mortgage insurance, the dream of home ownership would fail to materialize for many Americans. Lenders would simply not be willing to lend more than 80% of the value of a home because of the risks involved. The very existence of mortgage insurance allows people with little cash to realize the American dream. There are only a few ways for borrowers to avoid mortgage insurance. The first way is to save up, inherit, win or receive as a gift the 20% down payment. Alternatively, buying a lower priced home is an option. Otherwise, some type of mortgage insurance coverage will be required.

Mortgage Insurance Options

The cost of MI coverage is determined by LTV and the type of loan. Equally important, there are actually several different payment options available. More than 80% of all MI policies issued today fall under the "monthly premium" category. Under this option, the monthly cost for a $100,000 loan with 10% down would be about $43 per month. This premium plan has only been available for three years, but it is immensely popular because it requires little or no money up front. In the past, a borrower needed a sizable chunk of cash at the closing to pay for the MI. Monthly premium MI is ideal for the borrower with very limited cash. Because of the way down payment amounts affect the cost of premiums, any loan-to-value over 90% is an excellent candidate for this option. However, just because it is popular does not mean it is the best alternative for everyone.

"Standard annual" premium options require a sum of money up front at closing. The same $100,000 fixed rate loan with 10% down would require $600 at closing. While the monthly cost is the same for the first year, the annual renewal premium in the second year could drop to as low as $28 per month in this example. Generally, with loans at or below 90% of the value of a home, the standard annual policy is the better option if a borrower can afford additional payment due up front and also expects to keep the mortgage for at least three years.

"Single premium" mortgage insurance is a one-time lump sum paid for MI at the closing. At 90% LTV or below, the premium may be financed into the loan. Financing the one-time premium yields two positive results. It lowers the monthly cost of the insurance and provides a tax deduction of additional interest expense for borrowers who itemize tax deductions. However, the MI stays with the loan until it is paid off because it has become part of the loan. Also, only borrowers in the higher tax brackets will receive a worthwhile tax benefit. These single premium policies are best used as seller concessions. The seller can offer a percentage (3% for example) that will cover a non-refundable premium for the borrower, who will then never have to make an MI payment.

Another somewhat popular product is "lender-paid mortgage insurance," which is sometimes referred to as a "no-MI" option. The premium is simply added to the interest rate, making the separate payment invisible and creating a potential tax advantage similar to a financed single-premium plan. Again, as with single-premium, the MI is with the loan until it is paid off and the tax benefit is not as significant for lower income borrowers.

Finally, for the borrower who needs to qualify using the FHA mortgage programs, MI is usually built into the loan. This mortgage insurance premium (MIP) is relatively expensive as compared to loans insured by private mortgage insurers. For all the benefits that FHA mortgage programs offer, it is still advisable for a borrower to use conventional financing whenever possible.

With all of the options available, it is important for consumers to be informed of the choices by a qualified mortgage loan officer. The major criteria in deciding which MI plan to use are: loan-to-value, cash position, and expected holding period of the home and the loan. A seller concession for single premium MI is an effective way to avoid MI expense, when possible.

Dropping Mortgage Insurance

Nearly everyone asks when mortgage insurance can be dropped. Unfortunately, there is no perfect answer. Most mortgage insurance policies require that mortgage insurance stay in place for a minimum of two years, and that the mortgage loan has been paid on time for the two years prior to the cancellation request. After that point, when the loan-to-value on a home drops below 80%, the borrower must first pay for a licensed appraisal of the property to verify the property value. Then the borrower must request that the policy be cancelled in writing to the lender and that lender will consider the borrower's request. However, some lenders and investors will require MI coverage until even lower LTVs are reached, or until the loan is paid off. Others, on the other hand, may be more lax and only require one year of on-time payments. Because loans are routinely bought and sold on the secondary market, it is impossible to guarantee anything. Lenders remember the disastrous decline in property values during the late 1980s and are more careful about being protected. For most borrowers, however, if a strong case can be made that the LTV has dropped below 80% (either through appreciation in value or loan repayment), then the MI coverage will be dropped.

Mortgage insurance is a critical element of the American dream. With a little bit of information and planning, decisions can be made that are appropriate to an individual borrower's financial position and future plans.

Kirk A. Hagert is a wholesale account executive with First Bankers Mortgage Services in Glastonbury, CT, and a former employee of Mortgage Guarantee Insurance Corporation (MGIC).

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