Mortgage Insurance

It may seem that mortgage insurance only benefits the lender, and this in fact only pays out after your home is taken away from you, but the ultimate beneficiary of these policies is actually the homeowner. This does require us to think about mortgage insurance beyond the fact that this sort of thing adds to our mortgage payments and the lender is the one that is protected.

Mortgages involve significant risk to lenders even though they can take possession of your home and sell it to recover their investment in your property. When we buy a home, we put down part of the purchase price and borrow the rest. We are risking what we put up for the home, with the lender putting up the rest, where they are risking certain amounts of their stake should we default.

Banks are not eager at all to foreclose, as foreclosing on a property always involves a certain loss to them, whether or not they recover the full amount of the loan. There are administrative costs involved, as well as their losing the income stream, profits that they relied upon to make the loan profitable for them.

Mortgage InsuranceThe lender can take the principal paid back from a default and re-lend it, but these are loans they could have made anyway. This does not all work the way most people think, where someone deposits money in the bank and the bank then lends it out, and while there are limitations on what mortgage lenders can lend out, this is dependent on a number of factors that relate to a financial institution’s stability and solvency and they lend out far more than they have in assets.

This makes sense though because all you really need to cover off is the risk involved with these defaults, where only a small percentage of these mortgages will go bad and that’s taken into account in the equation along with other factors that relate to a lender’s financial stability.

It takes a lot to bring down a lender, things like the mortgage crisis of 2007-2009, and the massive defaults we saw back then did have an impact. These losses weren’t really borne by the lenders themselves, the originators as they are called, as debt like this gets sold off and the losses were borne by those holding the securities at the time of the housing crisis. Financial institutions did hold a lot of this and some got hammered, but not necessarily the ones that provided the initial loans.

Foreclosures are Not Pleasant for Either Us or our Bank

When a mortgage defaults, lenders aren’t in a position to just sit on the property and wait for the right buyer, as they are not in the property management business and do not speculate on such things. Rather, the property gets dumped on the market at well below market value. This can lead to much less than the appraised value getting paid back by way of the default, and these are risks that do impact a lender’s willingness to lend.

This is especially a risk if housing prices decline, and as they do, the lender’s risk exposure increases. Given that mortgages are taken out over such a long time period, and especially given that the risk of default and the housing market tend to go in opposite directions, these are risks that do need to be accounted for and will set some real limitations on a lender’s willingness to lend unless these risks are managed sufficiently.

In simple terms, if your home is worth $200,000 and you owe $180,000 on the mortgage, you currently have $20,000 in equity and provided that you keep up with the payments you do have a little wealth here. If you default, the bank will dump your property on the market, and this can not only make your equity disappear but can result in a deficit, losses that the bank will have to bear.

There’s also the matter of the property decreasing in value instead of increasing, where times start to get tougher for both you and the housing market, in the face of an economic downturn and especially during a recession. You lose your job, you can’t make the mortgage payments anymore, and your home’s market value goes down to $160,000. You’re already $20,000 in the red at best now, and the bank dumps the property on the market and gets quite a bit less than fair market value, making their losses even bigger.

Lenders rightfully want to have some protection against these things, and while there is always a certain amount of risk involved when extending mortgages, without your having mortgage insurance, lenders simply will not lend to you unless you have a big enough stake in the property, which is currently a minimum of 20%. Even then, the lender may still demand you take out mortgage insurance to make them feel comfortable enough, although this is not usually the case, but there may be times where the housing market is unstable and there may be excessive risk involved even though you do manage the minimum 20% down.

Even though your lender may sell off the debt, this all has to make sense downstream as well, because whomever ends up holding your mortgage requires this protection as well. All debt is an investment for those who hold it, and while the market for these investments are greatly expended over the old days when banks used to keep mortgages to themselves, these investments need to make sense for their investors.

Mortgage underwriting can be understood these days as a form of agency, and there are some big lenders that just serve as middlemen between borrowers and those who ultimately own the mortgages, which include a lot of ordinary investors as well through their funds investing in this mortgage debt.

Keeping Our Risks Manageable and Attractive

In order to make these investments attractive, and we know what can happen when things hit the skids, the default risk has to be kept to reasonable levels. We know that the housing market does contract as well as expand, even though it mostly expands, but when housing prices go down, and the loan was made based upon a higher or much higher home value, the risk of those holding the debt losing more money goes up.

Debt securitization might be seen as a bad thing by some, perhaps even an evil, but as long as we have a reasonable amount of transparency, this makes borrowing money to buy a home more efficient, allowing both greater access for borrowers as well as lower rates than otherwise would be possible.

Where once a lender was limited to their own resources, and even though this is not a matter of their having the money on hand to lend, this still would impact things like their reserve ratios, securitization of debt expands a lender’s capacity beyond their own means and into the lap of the world, anyone who cares to buy this debt. This is a good thing for everyone, the borrowers, the mortgage originators, and the investors who buy these mortgages.

With this as a backdrop, this all needs to go off in an orderly fashion, where lenders and those who ultimately are doing the lending are insulated from too much risk. Risk is priced into loans and this extends to mortgages as well, and we can rightfully view the mortgage payments we make as buying down our rates if lenders provided home loans that require insurance without them.

They don’t though, so this makes the decision much easier, which is between paying for the mortgage insurance or not getting the mortgage. The additional costs that not getting the mortgage range from the loss of future equity earned by buying now versus later to never getting a mortgage if they are never able to save enough to put up the 20% on their own.

We could borrow part of this down payment, but if we are relying on this, this will in themselves add to our risk of default and very often will end up disqualifying us for the mortgage itself. Unsecured borrowing both comes with higher rates and shorter amortizations, meaning that these payments will be larger per dollar borrowed than a mortgage would be, which are at lower rates and spread out a lot longer.

If your mortgage payment is $1000 for instance, and you are looking to borrow to get your down payment large enough to avoid mortgage insurance, and this brings up your overall payment to $1300 for instance, you now need to show that you can comfortably make this larger payment to qualify for the mortgage and purchase the home.

At best, this will involve your purchasing a lesser home than you would otherwise, and this will not only reduce your personal enjoyment, it can have big consequences down the road. The reason is that the more expensive home will appreciate a lot more in value over time, where when the market causes homes to double in value, where both the less expensive and the more expensive one doubles, this will make a huge difference in the amount of money you end up with.

On an out-of-pocket cost basis, you are saving the mortgage insurance premium, but you are also paying more for the interest on the amount of the down payment you borrowed, and that needs to be considered as well.

Without a Big Down Payment, Mortgage Insurance Is the Only Option

Where we most often end up is a situation where you simply cannot buy a home without mortgage insurance. This should not be seen as a necessary evil as what is required is instead a means of empowerment.

Before mortgage insurance came around, people used to be required to put down half of the value of the home before they could get a mortgage. This is not something that very many people could ever manage, and led to home ownership being either a matter of homes being passed down by parents or something that was only accessible to those of substantial financial means.

Mortgage insurance came to the rescue though and allowed many more people to buy a home rather than rent, where they now only had to come up with much more modest down payments and this really opened the door to home ownership generally. Even people with limited resources and not the greatest credit history can buy a house these days, although we did see this go too far in the period leading to the infamous mortgage crisis of 12 years ago where mortgages were handed out to just about anyone, but that was due to lack of transparency and not so much risk appetite exploding way out of hand.

For those of more modest income and wealth, mortgage insurance is simply a necessity, and it is not a matter of choosing whether to take it out or not, like mortgage life insurance or many other forms of insurance are. There may be some options here, such as whether you go with government-backed mortgage insurance programs or private mortgage insurance, and those who do not qualify for government insurance such as an FHA backed loan in the U.S., there are private mortgage insurers that can step in and fill this need.

The price of mortgage insurance does vary, and how this is priced depends primarily on your loan to value, or the ratio between the value of your home and your equity, which is your down payment in the case of a home purchase, but it also depends on other factors as well.

As we might expect, private mortgage insurance is more attuned to the market where public mortgage insurance is less flexible. Private mortgage insurance is therefore more customizable than public insurance and is also easier to get out of when the time comes where it should not be required, when your loan to value drops below 80% for instance.

Mortgage insurance may also be either paid by the lender and incorporated into your mortgage payments, or be paid by the borrower separately but still required, like property taxes and homeowner insurance are treated.

While this all might seem to be pretty complicated, it’s not that people are on their own here like they usually are with buying insurance products, as lenders are more than happy to assist with the process and do have the kind of knowledge that is required to guide us. In some countries this is all a very simple process anyway, you either have it or you don’t, and you need it, so you get it.

In other countries such as the United States, this can be a little more complicated in some cases anyway as there may be some options to choose among, but this can depend a lot on your individual circumstances and needs. This is where getting the right advise comes in, and we always should seek advice whenever we are uncertain about matters that will impact us financially.

Mortgage insurance is not something people tend to appreciate in the manner they should though, and it is actually a godsend for a lot of people, allowing us to get in the game of home ownership by making lenders comfortable enough to lend big amounts to us, beyond what they would normally entertain if not for the benefits of mortgage insurance.

This can lead to not only our being happier owning our own home, but using this as a real tool to build wealth over the years. Mortgage insurance does cost money, but unlike other insurance products, it does not protect us, it enables us, and enables us a lot in comparison with just renting all our lives and coming out with absolutely nothing to show for it. It therefore isn’t a bad thing, as it can instead be a fabulous investment.

Mortgage Insurance FAQs

  • What is mortgage insurance and how does it work?
    In order for a lender to offer mortgages, there must be a certain level of safety built in to the amount loaned out and the value of the property. Lenders don’t take their time selling foreclosed properties and they get lower than market value. Mortgage insurance permits those without the means to provide this safety through home equity to buy insurance instead.
  • How much does mortgage insurance cost?
    The FHA charges an upfront premium of 1.75% of the original mortgage amount, plus an annual premium that varies depending on how much of a down payment that you made. Making only a 5% down payment will cost you the most, where if you made a larger down payment, your annual premium will be less.
  • Do I need mortgage insurance?
    Mortgage insurance benefits lenders and not borrowers, so this is not anything we would ever choose when getting a mortgage. With the choice between paying it and not getting the mortgage, which is always the case, this makes mortgage insurance a requirement for those with less than 20% to put down on the purchase price of the home.
  • Is mortgage insurance a good idea?
    Mortgage insurance is a great idea because it allows many more people to buy their own home instead of renting. It can be challenging for a lot of people to save up enough to put 20% down on a home and this involves tens of thousands of dollars. Being able to get mortgage insurance is the difference between buying a home and not for most people.
  • Can you pay off mortgage insurance?
    Mortgage insurance is not paid off as it is a premium that borrowers pay to protect thier lender against their defaulting on the mortgage, where the insurance will make up for any losses that the lender suffers as a result of forfeiture. When you have enough equity in your home such that mortgage insurance is not needed, often times you can cancel it.
  • What is the difference between mortgage insurance and homeowners insurance?
    Mortgage insurance protects lenders against losses resulting from borrowers defaulting on their mortgage and the home subsequently being seized and dumped on the market to recover the principal amount owing. Homeowners insurance protects homeowners against losses resulting from damage to their homes and loss of their personal possessions.
  • Do banks offer mortgage insurance?
    Banks do not offer mortgage insurance because they are the beneficiary of mortgage insurance and they cannot both provide the coverage and collect the benefits with a policy, otherwise they would just be paying themselves. What happens is that borrowers take out policies with third party insurers to protect the bank against losses resulting from their mortgage.
  • How long do you pay mortgage insurance?
    Mortgage insurance is generally collected on behalf of insurers such as the FHA or private insurers from borrowers and included in their mortgage payments. This is not something that lenders can just leave up to borrowers as having this insurance is vital to maintaining the mortgage. Lenders will usually take no chances with this and make sure you pay it.
  • Do you get mortgage insurance back?
    Under the current FHA rules, once you have built up 22% equity in your home, which is the percentage of its value over and above what you owe on your mortgage, mortgage insurance is no longer required. While refunds are rarely given with insurance you didn’t need, in some cases you can get a partial refund of premiums paid provided you did not default.
  • Is mortgage insurance mandatory?
    Mortgage insurance is generally required when you take out a mortgage and provide a down payment of less than 20%, which is often the case when people get a mortgage. The problem is that lenders won’t lend without either the 20% or the insurance, to cover themselves one way or the other, so while this isn’t mandatory, it is required in practice.
  • Do all home loans require mortgage insurance?
    Mortgage insurance is only generally required when you put less than 20% down on a home, although in some instances a lender may still require that you take it out even if you do put down 20% due to other risk factors. Almost always though this need comes down to your down payment being less than the 20% that lenders require without insurance.
Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.