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Real Estate

2013-02-01 10:20:12

What is mortgage insurance and when do I need it?

Q-What is mortgage insurance and when do I need it? Is there any way to avoid it, or reduce the cost?

A-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 provided by either a public or private insurer. There is a way to save a lot on mortgage insurance for a conventional loan which I will cover later in my answer. Suppose Mr. & Ms Brown decide to purchase a house which costs $120,000. They pay 10% ($12,000) down payment and take out a $108,000 ($120,000-$12,000) mortgage on the remaining 90%. Lenders will often require mortgage insurance for mortgage loans which exceed 80% of the property’s sale price. Because of their limited equity, the lender requires that Mr. & Ms Brown pay for mortgage insurance that protects the lender against their default. The mortgage insurer will charge a premium for this coverage, which may be paid by either the borrower or the lender. If the borrower defaults and the property is subsequently sold at a loss, the insurer will cover the insured loss. To obtain public mortgage insurance from the Federal Housing Administration in the United States, Ms. Smith must pay an upfront mortgage insurance premium (UFMIP) equal to 1.75 percent of the loan amount at closing. This premium is normally financed by the lender and paid to FHA on the borrower’s behalf. Depending on the loan-to-value ratio, there may be a monthly premium as well. The United States Veterans Administration also offers insurance on mortgages. Private mortgage insurance Private mortgage insurance is typically required when down payments are below 20%. Rates can range from 0.5% to 6% of the principal of the loan per year based upon loan factors such as the percent of the loan insured, loan-to-value (LTV), fixed or variable interest rate, and the borrower’s credit score. The rates may be paid in a single lump sum, annually, monthly, or in some combination of the two (split premiums). Tax deductible In the U.S., payments by the borrower for either private or public mortgage insurance are currently tax-deductible on homes purchased after December 31, 2006. This deduction has been extended through 2013. It will depend on Congress as to whether this will be extended again past 2013. It might be prudent income tax planning to pay the mortgage insurance up front with a “single premium” so the deduction and tax savings will all be received in 2013 (see more on this below). It is possible that payments will not be deductible after 2013. You should consult with your CPA or professional tax advisor to determine your best strategy. Borrower-paid private mortgage insurance (BPMI) BPMI or “Traditional Mortgage Insurance” is a default insurance on mortgage loans provided by private insurance companies and paid for by borrowers. BPMI allows borrowers to obtain a mortgage without having to provide 20% down payment, by covering the lender for the added risk of a high loan-to-value (LTV) mortgage. The US Homeowners Protection Act of 1998 allows for borrowers to request PMI cancellation when the amount owed is reduced to a certain level. The Act requires cancellation of borrower-paid mortgage insurance when a certain date is reached. This date is when the loan is scheduled to reach 78% of the original appraised value or sales price is reached, whichever is less, based on the original amortization schedule for fixed-rate loans and the current amortization schedule for adjustable-rate mortgages. BPMI can, under certain circumstances, be cancelled earlier by the servicer ordering a new appraisal showing that the loan balance is less than 80% of the home’s value due to appreciation. This generally requires at least two years of on-time payments. Each investor’s Loan to Value (LTV) requirements for PMI cancellation differ based on the age of the loan and current or original occupancy of the home. While the Act applies only to single family primary residences at closing, the investors Fannie Mae and Freddie Mac allow mortgage servicers to follow the same rules for secondary residences. Investment properties typically require lower LTVs. Contracts As with other insurance, an insurance policy is part of the insurance transaction. In mortgage insurance, a master policy issued to a bank or other mortgage-holding entity (the policyholder) lays out the terms and conditions of the coverage under insurance certificates. The certificates document the particular characteristics and conditions of each individual loan. The master policy includes various conditions including exclusions (conditions for denying coverage), conditions for notification of loans in default, and claims settlement. The contractual provisions in the master policy have received increased scrutiny since the subprime mortgage crisis in the United States. Master policies generally require timely notice of default include provisions on monthly reports’, time to file suit limitations, arbitration agreements, and exclusions for negligence, misrepresentation, and other conditions such as pre-existing environmental contaminants. The exclusions sometimes have “incontestability provisions” which limit the ability of the mortgage insurer to deny coverage for misrepresentations attributed to the policyholder if twelve consecutive payments are made, although these incontestability provisions generally don’t apply to outright fraud. History Mortgage insurance began in the United States in the 1880s, and the first law on it was passed in New York in 1904. The industry grew in response to the 1920s real estate bubble and was “entirely bankrupted” after the Great Depression. The bankruptcy was related to the industry’s involvement in “mortgage pools”, an early practice similar to mortgage securitization. The federal government began insuring mortgages in 1934 through the Federal Housing Administration and Veteran’s Administration, but after the Great Depression no private mortgage insurance was authorized in the United States until 1956, when Wisconsin passed a law allowing the first post-Depression insurer, Mortgage Guaranty Insurance Corporation, to be chartered. This was followed by a California law in 1961 which would become the standard for other states’ mortgage insurance laws. Eventually the National Association of Insurance Commissioners created a model law. Save with “single premium” mortgage insurance. On a conventional mortgage where the loan is greater than 80% of the purchase price a lender will require mortgage insurance. If feasible, I always recommend that the borrower consider “Single Premium” mortgage insurance when taking out the loan. This will not only save on the total premium paid, but it will lower the monthly mortgage payment. For illustrative purposes only, I recently got a quote for the $148,000 loan on a $164,444 home purchase. The loan being 90% requires mortgage insurance. Based on the loan amortization schedule there would be 65 monthly payments to get to an outstanding loan balance of 80% of the original purchase price. The monthly insurance premiums were quoted at $ 67.83, for a total insurance premium cost of $4,409. On the other hand, a single premium cost was quoted at $ 2,057. By making the single payment the borrower saves $2,352 and lowers the monthly mortgage payment by $67.83, during the months that mortgage insurance is required. Since the premiums on mortgage insurance are currently deductible, for federal income tax purposes, through 2013, there should be additional saving in reduced income taxes. The above examples are for illustrative purposes only. Actual mortgage insurance premiums are subject to a borrower’s credit score, actual purchase price of the home, the loan amount and its percentage of the purchase, other factors that affect the borrower’s monthly cash flow and the financial position. Premiums for mortgage insurance can vary by insurance company and by the lender. Your CPA, professional financial advisor, attorney or other professional should be consulted to help you make the best decisions for your specific situation.