Mortgage Insurance

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Mortgage insurance compensates lenders for losses caused by the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer. In the United Kingdom, this type of insurance is called a mortgage indemnity guarantee (MIG).

For example, suppose a person buys a house which costs $250,000. The down payment might be 5% ($12,500) and the remaining 95% ($237,500) is financed with a mortgage. Lenders will often require mortgage insurance for mortgage loans which exceed 80% (the typical cut-off) of the property's sale price. Because it is possible that the value of the house could drop below $237,500, the lender then requires the mortgage insurer to provide insurance coverage at, for example, 25% of the $237,500 ($59,375), leaving the lender with a default exposure of $178,125.[1] 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 sold at a loss, the insurer will cover the first $59,375 of losses. Coverages offered by mortgage insurers can vary from 20% to 50% and higher.

Contents

History

Mortgage insurance began in the United States in the 1880s, and the first law regulating 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.[2] Mortgage insurance companies again suffered in the Recession of 2008.

In previous decades if a factory closed, whole neighborhoods were laid off simultaneously, workers no longer could afford mortgage payments, few buyers were interested in moving to areas in economic decline, and property values fell rapidly. Foreclosure insurance theoretically guaranteed the lender's investment at the original sale price or appraised value.

Claims against mortgage insurers were huge factors contributing to AIG's and Fannie Mae's insolvency.

Public mortgage insurance

To obtain public mortgage insurance from the Federal Housing Administration in the United States, a homeowner must pay an upfront mortgage insurance premium (UFMIP) equal to 1.75 percent of the loan amount at closing[3]. This premium is normally included in the mortgage amount and paid to FHA on the borrower's behalf. Depending on the loan-to-value ratio (LTV), there may be a monthly premium as well. The United States Veterans Administration also offers insurance on mortgages.[4]

Private mortgage insurance

Many lenders require private mortgage insurance when equity (or downpayment) is below 20%. The premium 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, and credit score.[5] The premium may be paid in a single lump sum, annually, monthly, or in some combination of the two (split premiums). In the United States, payments by the borrower were tax-deductible until 2010.[6]

If mortgage insurance is required in the monthly payment (or PITI - principal, interest, taxes and insurance) as it is in most cases, the higher monthly payment can affect the borrowers overall debt-to-income level in qualifying for a Fannie Mae-backed loan. [7]

Borrower-paid private mortgage insurance

BPMI or "Traditional Mortgage Insurance" insures against the loss caused by a default insurance on mortgage loans. It is 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. If home values increase, BPMI can be cancelled earlier by the servicer ordering a new appraisal showing that the loan balance is less than 80% of the home's new value. This generally requires at least two years of on-time payments. Each investor's 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. Lenders will require BPMI longer for investment properties until a lower LTV is met.

In Australia, borrowers must pay Lenders Mortgage Insurance (LMI) for home loans over 80% of the purchase price. Genworth Financial and QBE LMI are two of the largest Lenders Mortgage Insurance providers in Australia.[8]

Lender-paid private mortgage insurance

LPMI is similar to BPMI except that it is paid for by the lender. LPMI is usually a feature of high LTV mortgages that claim not to require mortgage insurance. The cost of the premium is built into the interest rate charged on the loan, and the borrower is often unaware of its existence.

Contracts

As with other insurance, an insurance policy is part of the insurance transaction. In mortgage insurance, the lender is the policy holder. A master policy states 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 states 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 do not apply to outright fraud.[9]

Insurance companies can rescind overage if the lender or borrower were involved in misrepresentation or fraud. In 2009, the United States District Court for the Central District of California determined that mortgage insurance could not be rescinded "poolwide".[9]

References

  1. MI Basics: What is MI?. MGIC.
  2. Jaffee D. (2006). Monoline Restrictions, with Applications to Mortgage Insurance and Title Insurance. Review of Industrial Organization.
  3. http://www.fha.com/fha_requirements_mortgage_insurance.cfm
  4. Home Loan Guaranty Services. United States Department of Veteran Affairs.
  5. Texas Department of Insurance. Private Mortgage Insurance (PMI).
  6. MI Basics: MI FAQs. MGIC.
  7. Fannie Mae guidelines for prime borrowers typically are expressed as 28/38, or 28% housing expense and 38% all forms of debt service. No more than 28% of a prime borrowers verified income can be used for housing expense and no more than 38% combined with all credit obligations (autos, credit cards, student loans, etc). Exceptions are allowed if the borrower shows other cash value assets, such as stocks, bonds, cash value life insurance, savings, etc.
  8. Lenders Mortgage Insurance. Home Loan Experts.
  9. 9.0 9.1 Ellison JN. (2010). Emerging Mortgage Insurance Coverage Disputes. Reed Smith LLP. MBA Legal Issues/Regulatory Compliance Conference.

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