Personal Solutions

Home  | Personal Solutions | Buying a Property  | Mortgage Insurance

Mortgage Insurance - where you pay to insure your lender.

Mortgage Insurance - Some Common Misconceptions

A survey of home borrowers a few years ago discovered that one in three borrowers believed that the "mortgage insurance" premium, which they had paid as part of their loan establishment fees, protected them should they fail to make a payment. Unfortunately only two of three borrowers were correctly informed.

The mortgage insurance premium paid by your as part of your loan establishment fees DOES NOT protect you, the borrower, in the event of a default. The mortgage insurance guarantees that the lender can recoup certain losses that may be sustained as a result of lending to you. For this reason, it is normally referred to as Lender's Mortgage Insurance (LMI) to distinguish it from the mortgage protection insurance which protects borrowers, (we will deal with this in our next issue).

What is covered by LMI?

• Loss of principal
• Unpaid interest
• All reasonable recovery costs such as legal fees, marketing costs, repairs, maintenance, and outstanding rates

What is not covered by LMI?

• The borrower (or guarantor where applicable)
• Break costs on fixed rate loans
• Physical damage to the security (normally covered under a general insurance policy)
• Fees and charges not directly related to costs incurred by the lender in recovery of the debt

How Does LMI Work?

Say you fail to meet your mortgage payments. The lender will then attempt to recover the outstanding portion of the loan by selling the property. If the sale of the property does not cover this outstanding amount, then the LMI will make up the difference and then pursue you for this amount. Thus LMI is actually an undertaking by an insurance company to share the lender's risk - that is, the risk that there is a shortfall after the sale of the property and you can not or are not around to make up the difference.

So - how can we account for the (slightly worrying) fact that perhaps a third of borrowers have floated through life with the completely misguided, belief that they had insured themselves against tough times? The answer may lie in another revelation in the same survey. Namely, that 70% of borrowers claimed that they did not fully understand the information given to them by their mortgage provider.

The correlation between the two figures is obvious enough. In the absence of clear and succinct information, many borrowers are left in the dark as to the precise detail of what they are getting themselves into. The lucky ones who do know their loan in and out, sort the help of professional mortgage consultants.

What are the benefits of LMI?

For the Lender

LMI minimizes the risk of loss on low deposit housing loans. It gives lenders the confidence to approve more mortgages and enhances their ability to lend to broader range of customers. This helps lenders maintain their competitiveness in the home loan market.

For the Borrower

Essentially this gives people, with less deposit, the opportunity to enter the property market. LMI allows property investors to have a higher lending ratio, giving them the opportunity to leverage off the associated benefits of negative gearing.

Do I have to pay LMI?

The simple answer is No, but the chances are that you won’t be getting the loan you applied for. Although the lender is the insured party, the borrower will pay the LMI premium in the majority of instances. Generally, when you borrow more than 80% of the property's assessed market value, you will be expected to pay the lender's mortgage insurance.

Lenders tend to consider the loan-to-value ratio (LVR) to be a simple index of the level of risk involved in financing a given purchase. Thus when the LVR is 80% or higher, the lender's risk is increased, and the lender will ask the borrower to meet the cost of covering this risk.

In most cases therefore, the only way of avoiding paying a lender's mortgage insurance premium will be to wait until you have a deposit of greater than 20% of the property value before seeking a loan. Although this will save you having to pay the relatively hefty LMI premium, this approach has obvious drawbacks. While you cool your heels in rental accommodation scraping together a larger deposit, you may miss out on the perfect home, or the perfect moment to enter the home loan market. For this reason, most informed borrowers view lender's mortgage insurance as an unpleasant, but unavoidable part of the borrowing process.

How Is LMI Calculated?

LMI premiums are calculated on a sliding scale taking into account the LVR, loan product, loan amount, geographic location and insurer. Typically, the premium will be a percentage of the borrowed amount. As a rule of thumb, the higher your LVR the higher this percentage will be. For example, on a $400,000 loan at an LVR of 85% your LMI premium may be charged at, say, 0.88% of the borrowed amount, being $3,520. If, however, you have borrowed $400,000 at an LVR of 90%, your LMI premium may be closer to 1.24% of the borrowed amount, being $4,960.

How Do I Pay It?

Lender's mortgage insurance can be paid either upfront as a lump sum, or added to the loan capital. This latter will only be possible if it does not increase the LVR above the maximum which the lender will tolerate (usually 97%, but sometimes lower). In any case the upfront payment will be the better option, since no interest will be levied on the premium.

What Else Do I Need to Know?

Perhaps most important to keep in mind is the fact that LMI introduces another unseen party to the negotiation of a home loan. Behind the smiling face of the mortgage provider is the cold and papery hand of the lender's insurer. Since they are sharing in the risk of the loan, the insurer will reserve the right to veto your loan application even if the lender has accepted it. This is particularly relevant to financing the purchase of a property bought off the plan, or a very small apartment.

Also worth considering is the commission paid by the insurance company to the lender. Under the terms of the uniform consumer credit code (UCCC) the borrower must be made fully aware of any costs associated with LMI before entering the loan. Make sure you find out whether you are being slugged with these commissions, in addition to the premium itself, before you sign on the dotted line