Mortgage Insurance
Mortgage insurance still remains a very effective method of your house protection against possible misfortunes. We make definition of mortgage insurance and describe how it is understood today. We analyze the protection factors of mortgage insurance and ways of measurement the cost of mortgage insurance. We also discuss some disadvantages of the present situation with the mortgage insurance.
Definition and understanding of mortgage insurance
Mortgage insurance is an insurance policy which compensates lenders or investors for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer. The policy is also known as a mortgage indemnity guarantee (MIG). Mortgage life insurance guarantees repayment of a mortgage loan in the event of death or disability of the borrower.
For example, somebody decides to buy a house, which costs $150,000. He pays 10% in $15,000 down payment and takes out a $135,000 mortgage. Lenders will often require mortgage insurance for mortgage loans which exceed 80% of the property's sale price. Because of limited fair play, the lender requires that the borrower pays for mortgage insurance that protects the lender against his default. The lender then requires the mortgage insurer to provide insurance at 25% coverage of the 135,000, or $33,750, leaving the lender with an coverage of $101,250. The mortgage insurer will charge a premium for this coverage, which may be paid by the borrower or the lender. If the borrower defaults and the property is sold at a loss, the insurer will cover the first $33,750 of losses. Coverage offered by mortgage insurers can vary from 20% to 50%.
To obtain public mortgage insurance from the Federal Housing Administration, the borrower must pay a mortgage insurance premium (MIP) equal to 1.5 percent of the loan at closing. This premium is financed by the lender and paid to the Federal Housing Administration on the borrower's behalf. Depending on the loan-to-value ratio, there may be a monthly premium as well.
Protection by Mortgage Insurance
Mortgage insurance protects the lender against loss in the event that the borrower defaults. The borrower pays the premium, but the lender receives the protection.
Mortgage insurance has no connection to any kind of life insurance, and pays no benefits to borrowers. The only benefit received by the borrower is that, with mortgage insurance, lenders are willing to make loans with down payments smaller than 20% of buy price or assessed value.
Importance of Mortgage Insurance and reasons to use it
Mortgage insurance is an alternative to a larger down payment, and also to a second mortgage for the amount of the loan above 80% of property value. Knowing the cost of mortgage insurance is useful in deciding which of these options is least expensive to the borrower.
For instance, you have been advised not to borrow more than 80% of the value of your property so that you will not have to buy mortgage insurance. The insurance premiums you have been shown only amount to about ¾ of 1% of the loan balance per year, which seems small, but judgments of "small" and "large" are subjective with mortgage insurance.
How to measure the cost of Mortgage Insurance
Measuring the cost of mortgage insurance is difficult, but the measurement is just the first step. The second step is to decide what it means for you and you must do it yourself. It is necessary to know how to convert the mortgage insurance decision into an investment decision, which more people are familiar with.
For example, you can obtain a 15-year fixed rate mortgage at 7.5% and zero points to purchase a $100,000 house. Without mortgage insurance, you could borrow up to $80,000 (80% of property value), whereas with mortgage insurance you could borrow up to $95,000 (95% of property value). The insurance premium on the $95,000 loan is .79% of the balance per year for the first 10 years, after which it drops to .20%.
The best approach to measure the cost of the insurance premium is to view the loan of $95,000 as consisting of 2 loans: one for $80,000 which has an interest cost of 7.5% consisting only of the interest rate; and one for $15,000 the cost of which includes both the interest rate and the insurance premium. The interest cost on the $15,000 loan turns out to be 12.7% if you stay in your house for up to 10 years, declining slowly after that to 12% if you stay a full 15 years.
Since the insurance premium is only .79%, how can the cost of the $15,000 loan be 5.2% higher than the cost of the $80,000 loan? The reason is that while you are borrowing an additional $15,000, you pay the premium on the entire $95,000.
Mortgage Insurance and the cost
The cost calculation assumes that you take a fixed-rate mortgage with a loan-to-value ratio of 95%, and pay mortgage insurance for 10 years. Change the assumptions and you change the cost. For example:
*On 85% and 90% loans, the cost is 13.4% and 12.5%, respectively. While the insurance premiums are smaller, the incremental loans are also smaller.
*On smaller loans within the same mortgage insurance premium bracket, the cost is higher. For example, the cost of insurance on a 91% fixed-rate loan, which has the same premium as a 95% loan, is 14.3%.
*Adjustable rate mortgages have higher insurance premiums, and therefore higher costs, than fixed-rate mortgages.
Mortgage insurance costs can be reduced if you get the insurance removed early. For example, if the insurance on a 95% fixed-rate mortgage is removed in 5 years but you stay with the mortgage for 10, the cost falls to 10.8%. However, if you move in 5 years and pay off the mortgage, there is no saving.
Estimating Incremental Cost
The rule-of-thumb is intended for estimating the interest cost on the incremental loan assuming the loan runs 10 years. Divide the total loan by the incremental loan and multiply the result by the annual insurance premium, e.g., 95,000 divided by 15,000 equals 6.33 which multiplied by .79% equals 5%. Adding that to the interest rate gives an estimated cost of 12.5% on the incremental $15,000 loan.
Avoidance of Mortgage Insurance
Is an increase in interest cost of 5 percentage points on the incremental loan? The best way to answer this question is to view the choice between the smaller loan without insurance and the larger loan with insurance as an investment decision. Taking the smaller loan means investing $15,000 in a larger down payment that provides a risk free return of 12.5%. It is not an attractive investment if you do not have the $15,000. Even if you have it, you would be locking it up for an indefinite period, although you might borrow against it using a home equity loan. Or you may not be impressed with a 12.5% return if you can earn more than that in your business, or are paying more on credit card loans. On the other hand, if you have a bond portfolio earning 7%, you might well want to liquidate it to invest in the larger down payment. In short, a 12.5% cost on an incremental loan made possible by mortgage insurance will be "small" to some and "large" to others.
Reduction of the Mortgage Insurance cost
Competition in the market for mortgage insurance is cruel, in that it is not directed at the borrowers who buy the insurance. Rather, it is directed at the lenders who select the insurer, which has the effect of raising costs to the insurer and premiums to the borrower.
It is sometimes useless to shop for mortgage insurance. While you could insist on selecting the insurer, there is not much point to it because the premiums charged by different companies are either identical or so close that the difference would not pay you for the trouble.
Competition in the Mortgage Insurance Market
There is competition in the mortgage insurance market, but it is the kind that raises prices rather than reducing them. Some economists call this "perverse competition".
Perverse competition arises in markets where the consumer purchasing a big-ticket item from A must also purchase a smaller item from B, C or D, and A is in a position to direct or refer the buyer to one of them. Since B, C and D can get access to the consumer only through A, they compete among themselves for A's favor in ways that raise their costs, and hence prices to the consumer.
This is exactly how the mortgage insurance industry works. The consumer pays for the insurance, but ordinarily has no direct contact with the insurer. All merchandising by the insurers is directed toward lenders. So long as they can't be accused of steering their customers to an insurer that charges more than another insurer, lenders are largely indifferent to the price charged the consumer. Their goal is to profit from their strategic position as a referral source. Competition by the insurers for referrals of business generates benefits for lenders, not consumers.
Referrals in Mortgage Insurance
Lenders are not paid directly for referrals of mortgage insurance business. Referral fees are illegal. But there is more than one way to circumvent the law. Mortgage insurers have always provided services of one sort or another to lender-customers, free or at bargain prices. In recent years, an increasing number of lenders have established captive mortgage reinsurance affiliates which have no other purpose but legitimizing referral fees.
The Department of Housing and Urban Development has set up elaborate rules regarding both of these devices that lenders must follow to avoid violating the law. These rules do not help the consumer. On the contrary, they legitimize the practice of concealing referral fees, while raising the cost of receiving them. So long as consumers are the ones paying for mortgage insurance, they probably would be better served if referral fees were legal and open for all the world to see, and lenders were not forced to incur significant expense to collect them.
Reducing Mortgage Insurance Premiums
But the best remedy is to eliminate perverse competition by requiring that mortgage insurance be paid for by the lender. This rule would immediately drive down mortgage insurance premiums, since insurers would then be obliged to compete in terms of premiums rather than referral fees. It would eliminate the referral fees into something that doesn't look like a referral fee. And it would end the contentious issue when consumers can cancel their mortgage insurance. If lenders buy the insurance, cancellation becomes an issue between the lender and the insurer. In case lenders buy the mortgage insurance, they will pass on the cost to consumers in the rate. The premiums added to the rate will be lower, and borrowers can shop for rates. The rate increase that the lender tacks on to cover the cost of insurance is deductible to the borrower, where a mortgage insurance premium paid by the borrower is not. This rule would confer immediate and measurable benefits.