Mortgage insurance is an insurance policy used to protect mortgage lenders /originators/underwriters by transferring the tail risk from lenders to insurers. In other words, this insurance policy provides the additional housing finance flexibility to both lenders and consumers (borrowers) through expansion of ‘underwriting envelope’ along the ‘loan-to-value’ band. The leverage offered to the borrower is repayable over a period of time for nominal premium rates to the mortgage insurer.
In simple terms, mortgage insurance reduces the risk of the lender and makes you qualified for a home loan that you might not have been able to get otherwise. It is an integral part of mortgage processing in USA. It makes home ownership possible with low down payment, thereby replacing personal guarantee and ensuring your dream fulfilment for a home.
How does it work? Who benefits whom?
Borrower wants to buy a house by has shortage of money for down payment
But due to increased risk, lender and investors prefer mortgage insurance for loans with less than 20% down payment
Mortgage insurer providers assume a portion of lender’s mortgage risk thereby shielding taxpayers from unwanted liability
Hereby, mortgage insurance companies offer the residual down payment to borrowers to attain eligibility for loan from the lender in lieu of monthly/annual premium. Also, premium from the lender is also collected
The Lender recovers the cost of premium paid to lender from the borrower in the form of higher interest rates
Numerically, the benefit of mortgage insurance to both borrower and lender can be explained as:
● Property value = $1,00,000
● Down payment made = 10% of the property value i.e. $10,000
● Loan availed = $90,000
The borrower can own a home with just 10% of down payment rather than saving for few more years or surrendering the entire 20% of the property value as down payment.
On the other hand, Mortgage Insurance 25% coverage (on loan value) = $22,500
Therefore, Lender exposure is 67.5% of the property value = $67,500
Generally, a 25% Mortgage Insurance coverage is required for 90% loan-to-value; wherein during claim, the mortgage insurer is responsible for the payment of 25% of the outstanding loan balance. In this way, the lender is exposed only to a risk of 67.5% and thereby the lender benefits with reduced risk exposure.
To make the concept clear, let us consider this case study.
Everyone wants to own a house but quite a lot are limited by the constraint of money/finance irrespective of years of savings. Now this financial constraint can be categorised into two cases:
a.) The finance available with the potential buyer is not enough to fulfil the mandatory requirement of 20% down payment by the lender
b.) The potential buyer, irrespective of having enough money for the mandatory 20% down payment, is not willing to let go of all savings and advance towards money crunch for other operational costs
It might also occur that the purchasing conditions or real-estate market is favourable and still the lucrative offers could not be availed pertaining to the finance constraints of the potential buyer or increased risk danger of the financial institutions, which indeed is a macro-economic issue.
In order to resolve the greater failure circuit and consequently benefiting the trio in the equation (buyer/borrower, insurer and lender), the mortgage insurer offers the remaining percentage of the mandatory 20% down payment, post the borrower’s own feasible contribution to the later.
On the other hand, political, geographic, economic and several other risk parameters curtail the optimism of financial institutions to lend out loans and defer defaults/LPAs. In such situations, mortgage insurance offers reduced risk and streamlined loan management to lenders to increase their mortgage deployment capability and ensure increased mortgage quality as an asset.
It acts as a win-win for both lenders looking for safer investments and investors opting for secure purchase. Consequently, mortgage insurance helps borrower attain qualification for a home loan with comparatively smaller down payment and on the other hand protects the lender’s interest in case of borrower’s default on residential mortgages.
A complete beneficiary model for borrowers, lenders and the insurer itself!
The trio involved in mortgage insurance equation, benefits simultaneously from the business model and in turn reduces burden for each other.
Let’s unfold some of them:
For the lender:
- Expanded portfolio: The lender benefits from the availability of broader range of loan products/portfolio with comparatively safer investments
- Risk Protection: Since the risk is averted by almost 25% (also in high-loan-to-value risks) with the inclusion of mortgage insurance in property loan, the lenders can easily loan out larger quantity of clients and can also bailout in adverse situations
- Larger Clientele Base: With availability of an assurance of shared risk and financing of down payments, the lenders actually benefit from expanded pool of property buyers with lower cash capabilities and number of mortgages offered to applicants
- Mortgage Management: This is made possible with effective due diligence and information management strategies along with proper loan estimation and mortgage valuation
- Informed Decisions: Mortgage insurers include data analysis, portfolio assessment, mortgage/property valuation , risk administration, among others to create maximum value for their investments which inturn helps lenders in averting defaulters and creating a strong loan client base
For the borrower:
- Reduced financial strain: Mortgage insurance eliminates the need of lump sum down payment or upfront premium amount (in case of FHA borrowers) by borrowers, thereby reducing the burden of cost and ensuring property ownership
- Increased buying power: Mortgage insurers omits the need to compromise for our dream house due to lack of sufficient savings
- Availability of better cash in hand: With comparatively lower down payment, the borrower is left with sufficient cash-in-hand for other operation or home-related purchases/repairs/investments
- Benefit of low/predicted monthly payments: Mortgage insurance is available at very low rates and can be easily paid on monthly instalments. However, these rates differ based on the kind of mortgage insurance one has opted for.
As in insurance, which in itself is a huge umbrella, mortgage insurance varies with the kind of loan the borrower applies for, with the lender.
a.) Conventional Loan
In general, if applied for conventional loan with down payment of less than 20%, lender automatically arranges for a mortgage insurance which is mainly a private mortgage insurance (PMI). The premium is determined on down payment % and borrower’s credit score and has a clause for cancellation under certain circumstances.
b.) Federal Housing Administration Loan (FHA)
FHA mortgage insurance is mandatory for any applicant of FHA loan and the premium amount is exclusive of borrowers’ credit score. The premium amount can be increased slightly if the down payment made is <5%. This policy includes both upfront payment at closure and monthly instalments.
The policy comes with no cancellation policy until a down payment greater than 10% has been made.
c.) US Department of Agriculture Loan (USDA)
Similar in lines with FHA mortgage insurance with slight difference in premium, which is favourably lower.
d.) Department of Veteran’s Affairs (VA) backed Loan
These loans are intended to serve ex- and existing servicemen, veterans and their families. Under this policy, payment is made as an up-front funding fee with no monthly mortgage insurance premium and low interest rate.
Since PMI is the most conventional and popular option opted for, let’s segregate and learn the various offers available under its different types:
Private Mortgage Insurance (PMI)
This is usually a mandatory requirement/condition in conventional mortgage loan cases whereby:
- The down payment made is less than 20% of the property value
- When the borrower is refinancing with conventional loan with equity value less than 20% of property value
The PMI can be availed at an additional cost of premium (ranges between 0.25%-2% of the loan balance per year) to be paid monthly until the borrower accumulated enough equity on the property to be not considered a high risk. The premium is directly (and highly) dependent on risk factors and also on borrowers credit score.
Unlike other insurance that safeguards the insured’s interest, PMI safeguards lender’s investment.
Further, the duration of the PMI depends on the type of PMI chosen by the borrower. Broadly, PMI can be segregated into five types based on premium payment method:
- Borrower – Paid Mortgage Insurance (BPMI)
Classified as the most common and perceived to be the kind if no particular PMI type is mentioned in the policy; BPMI is paid in the form of an additional monthly premium along one’s mortgage payment. This insurance’s duration is limited until 22% of the equity value of the property (based on the original purchase price) has been paid by the borrower. Additionally, the lender can also automatically cancel the policy if the borrower makes regular mortgage payments.
- Single Premium Mortgage Insurance (SPMI)
Also known as Single-Payment Mortgage Insurance, the borrower can pay mortgage insurance as a lump-sum amount either in full at closure of the policy or financed into the mortgage.
The major benefit remains in lower monthly payments as compared to BPMI with no worries about refinancing. SPMI is beneficial if the borrower plans to stay in the house for 2-3 years.
- Lender-Paid Mortgage Insurance (LPMI)
In this case, the lender pays the mortgage insurance premium on behalf of the borrower, which the latter repays over the period of loan as a higher interest rate. This insurance comes with a condition of non-cancellation and non-refundable clause even if the borrower’s equity on the property reaches <70% since it is built on the loan. The only way possible to lower SPMI is refinancing.
Despite the flaws, SPMI is preferred by borrowers looking for lowered monthly payments and an eligibility to borrow more.
- Split – Premium Mortgage Insurance
A hybrid of BPMI and SPMI.
The plan allows part of the mortgage insurance to be paid in a lump-sum at closure and the rest as monthly payments. It also gives the benefit of no requirement for complete lump-sum payment as in SPMI nor increased monthly payments as in BMPI along with advantage of higher debt-to-income-ratio.
Herein, the monthly premium is calculated on the basis of net loan-to-value ratio before factoring of any finance premium.
In terms of refund, split premium is partially refundable when mortgage is terminated.
- Federal Home Loan Mortgage Protection (MIP)
This type of mortgage insurance is mandatory for borrowers buying U.S. Federal Housing Administration (FHA)-backed mortgage, irrespective of the percentage of down payment made. MIP required upfront payments while the monthly premium is added to the monthly mortgage payment instalments.
This policy can be cancelled post 11 years only if the down payment made was more than 10%.
Factors Determining the Mortgage Insurance Premium
While one choses the type of mortgage insurance plan they want to avail, knowledge about the factors that would determine their mortgage insurance cost/premium is very important. On a general note, as agreeable with any insurance – higher the risk-higher the premium rule also applies on mortgage insurance policies. Similarly, premium to be paid by the borrower and the premium to be charged by the insurer depends on several factors including:
- Percentage of down payment made/ Loan-to-value ratio
- Amount of mortgage insurance coverage required by lender
- Loan term
- Mortgage Value/property value
- Complete assessment of the loan (by the lender) in terms of geographic location of the property, employment status of the borrower, loan purpose, amounts, etc.
- Borrowers credit score
The lenders’/financial institutions also assist the borrowers in analysing the appropriate mortgage insurance to be availed by them for maximum benefit and coverage.
The Bottom Line
The concept of mortgage insurance benefits all the parties involved particularly the borrower and the lender. It enables a streamline loan process that benefits the borrower to own a property earlier and of own choice rather than compromising on time, affordability, likeliness and savings while helping the lender to broaden and strengthen its loan portfolio.
As with every good offer, a slight increase in cost in the form of additional premium payment to mortgage insurance would not pinch the potential buyer/homeowner as hard as it would to lose a great real-estate offer or a beautiful dream house. Similarly, mortgage insurers help the financial institutions in better property valuation and risk management in high loan-to-value ratios.
Frequently Asked Questions:
Is Mortgage Insurance Industry Government Regulated and Safe?
On a larger/macro scale, the efficiency of mortgage insurance can decline during a crisis (as in the current pandemic of Corona) since the mortgage default risk is inherently co-related with the real estate, mainly the housing sector, banking sector and ultimately the economic environment. Similarly, with greater proportional risk, government ensures strong prudential supervision of Mortgage insurance industry. The mortgage insurers are regulated and supervised by legal entities and local insurance supervisors.
Is Mortgage Insurance a Mandatory Insurance in Case of House Loan?
Yes. In case the potential home buyer cannot make the 20% down payment of the entire value of the property, the lender can direct him for a mandatory mortgage insurance to mitigate the risk of default.
However, the compulsion of the mortgage insurance varies from jurisdiction/country. It might in some case be omitted based on several other factors.
What are the Different Payment Methods of Mortgage Insurance?
Mortgage insurance can be paid off as ‘pay-as-you-go’ premium payment or can be capitalised as a lump sum payment during mortgage origination. In case of, PMI, borrower can request for cancellation of mortgage insurance once the 20% of the principal balance of the property has been paid off successfully.
Can Mortgage Insurance be Avoided?
Avoidance of mortgage insurance is available only if down payment of 20% is made upfront to the lender. Since, the risk is reduced considerably, mortgage insurance is not applied. However, in case of FHA loan, it cannot be avoided irrespective of the down payment percentage.
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