Mortgage Insurance

The HO mortgage clause protects creditors making loans secured by the insured property. A mortgage is evidence of a debt. It is the security agreement when a loan is made on real estate. A mortgage gives the lender (mortgagee) a legal interest in the property mortgaged. If the borrower (mortgagor) defaults on the loan agreement, the mortgagee may foreclose on the mortgage and sell the property to satisfy the debt. Both the mortgagor and mortgagee have an insurable interest in the property.

To illustrate the mortgage clause, consider the case of Genghis 0. Kahn. Genghis recently purchased a $250,000 house in Ephraim, Wisconsin. He used $50,000 of his own money for a down payment and borrowed $200,000 from the Eighteenth National Bank of Ephraim. To secure the loan, he mortgaged his new home to the bank. If an uninsured loss occurred, Genghis would lose not only his $50,000 down payment, but would still owe the bank $200,000. The bank would have some land and a pile of ashes as security for a $200,000 loan. Considering the nomadic ways of Genghis, these ashes would not be overwhelming security.

To protect the bank's interest, the bank could require Genghis to purchase insurance and add the Eighteenth National Bank as an additional insured. If, however, any action on the part of Genghis (such as an attempt to defraud the insurer) were to result in suspension of the coverage, the bank could lose its insurance protection. As a second alternative, the bank could purchase its own insurance. There are many problems when the lender insures mortgaged property separately. Rather than probe these complex issues, consider the solution: the standard mortgage clause.

What is the real cost of mortgage insurance?

Lenders require mortgage insurance on any loan that exceeds 80% of property value. The larger the loan relative to value, the higher the insurance premium. While the insurance premium is assessed against the entire loan, the cost should be allocated entirely to the portion of the loan that exceeds 80% of value. Assume I can obtain a 30year fixed rate mortgage at 7.5% and zero points to purchase a $100,000 house.

Without mortgage insurance, I could borrow up to $80,000 (80% of property value), whereas with mortgage insurance I 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 measuring the cost of the insurance premium is to view the loan of $95,000 as consisting of two loans: one for $80,000, which has an interest cost of 7.5% consisting solely 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 30 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.

The cost calculation above 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 manage to get the insurance removed early. For example, if the insurance on a 95% fixed-rate mortgage is removed in five years but you stay with the mortgage for 10, the cost falls to 10.8%. However, if you move in five years and pay off the mortgage, there is no saving. Here is a handy rule-of-thumb for estimating the interest cost on the incremental loan made possible by mortgage insurance, 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 when multiplied by .79% equals 5%. Adding that to the interest rate gives an estimated cost of 12.5% on the incremental $15,000 loan.

The choice between a smaller loan without insurance and a larger loan with insurance can be viewed 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%. Is this an attractive investment?

Not if you don’t 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.

How can I avoid private mortgage insurance?

In addition to putting 20% down, there are two other ways to avoid purchasing private mortgage insurance (PMI). One way is to pay a higher interest rate in lieu of PMI. When a borrower accepts this option, the lender buys PMI for less than the borrower would have to pay. The higher interest rate covers the insurance cost to the lender plus a profit margin. Some but not all lenders offer this option.

The sales pitch for the higher rate as a replacement for PMI is that interest is tax deductible whereas PMI premiums are not. The other side of the coin, however, is that you must pay the higher interest for the life of your mortgage, while mortgage insurance will be terminated at some point.

On most loans closed after July 29, 1999, mortgage insurance must be cancelled at the borrower’s request if the loan balance is paid down to 80 percent of the original property value. Further, insurance must be terminated automatically when the balance reaches 78% of the original value. In addition, subject to certain conditions, PMI on loans sold by lenders to the two federal agencies (Fannie Mae and Freddie Mac) must be cancelled when the loan balance reaches 80% of the current property value, taking account of appreciation. In general, if you expect significant appreciation and monitor your property value so you can terminate PMI as soon as possible, the higher interest rate option is a poor choice— unless you expect to hold the mortgage a very short time. In other cases, it could be a good choice.