Mortgage Insurance Explained

One of the most misunderstood elements of the home loan application process is the role played by mortgage insurance.

The term mortgage insurance is in itself misleading because it does not mean that an applicant's mortgage is insured for them.

Mortgage insurance is more correctly termed Lenders Mortgage Insurance, because it is the lender who is insured, not the borrower.

The idea of mortgage insurance came about in response to banks exceeding their normal safe lending margins in order to extend credit to predominantly first home buyers.

Here is how it works.

Most banks regard a safe lending margin to be no more than 80%. In other words they will lend up to 80% of the property's value and the borrower contributes 20% towards the purchase. So, if a borrower has a 20% deposit and extra funds to pay for legal expenses, application fees and the like, the bank will regard this as a safe loan and, provided all other criteria are met in the loan assessment process, the loan is likely to be approved.

As banks became more competitive they became keen to lend money to borrowers who were unable to save a 20% deposit, but who would otherwise have qualified for a loan. So, they extended their lending guidelines to incorporate borrowers with low deposits but in order to safeguard themselves, decided to insure the loan so they could be recompensed in the event that the borrower could not repay it.

Specialist insurance companies then began to offer mortgage insurance products to these lenders but, in order to protect themselves against possible claims, began to impose their own requirements. These requirements were stricter than normal bank lending guidelines and as a result borrowers now have to meet stricter criteria when applying for loans with a higher than 80% loan to value ratio.

The bottom line is that in order to qualify for a loan when borrowing at these higher margins, stricter guidelines will be enforced by banks on behalf of the mortgage insurance companies. This means that borrowers have to prove they have been in their current position for more than six months and in the same industry for at least 12 months and that they are earning sufficient money to repay the loan as determined by the mortgage insurer, not the bank.

This mortgage insurance policy is one of the most expensive parts of any loan application and because of the expense involved, the bank passes this cost on to the borrower and this is often overlooked.

What does lenders mortgage insurance cost?

For first home buyers premiums are calculated as a percentage of the loan amount. As at 1 July 2010 the amount charged varies from 0.37% up to a maximum of 2.48% of the loan amount. So you can see that the cost can be quite substantial given that a $400,000 loan with a loan to value ratio of 95% would cost $9920.

How do you pay for lenders mortgage insurance?

Some banks can be quite generous in this respect by adding the cost of the mortgage insurance premium on to the loan amount so that the borrower does not have to be concerned about it too much. As the global financial crisis took hold however, this generosity contracted considerably and as at August 2010 only a few banks offer this facility. This means that if you do not choose the correct bank or loan product you will have to save this premium on top of your deposit and other costs.

There is a real sting in the tail here for unwary borrowers because the savings required can be quite onerous. Consider the following example. Borrowers looking to purchase a house valued at $500,000 will need to save 5% of that amount, $25,000 plus legal costs and other application fees and duties of around $2000.

But, to pay the lenders mortgage insurance premium they will have to save an extra $11,780, almost half of the 5% that is required as genuine savings in the first place. Therefore, the total fees +5% genuine savings really amounts to $38,780 or almost 8% of the house value.

In summary, here are the important facts about mortgage insurers you need to know before starting your house hunt as a first home borrower.

Lenders Mortgage Insurance is an insurance policy that protects lenders not borrowers.

The premium for this insurance is payable by the borrower, and the amount can be quite substantial depending upon the amount borrowed and the loan to value ratio.

It is a once only payment payable at the start of the loan. It is not a yearly premium that needs to be paid forever.

If the anticipated premium makes it difficult for you to save the extra money on top of your normal 5% deposit, try to find a bank that will capitalise the premium into your loan.

Obtain an accurate quote for the mortgage insurance premium from your mortgage broker or lender before you start looking for a home.

Copyright © 2010 - Homeloans Central. All rights reserved. Web Design & SEO by Web Profits.