I heard a very compelling ad on the radio yesterday. A large, very well-known national lender came up with a new program where you can avoid mortgage insurance – because the lender pays it for you! An offer this generous will, of course, make the phones ring off the hook. The cynics among you, however, might be thinking “What’s the catch?” You untrusting soul, you.
Well, let’s look at the offer. It turns out this “new” program – which has been possible for a decade or so – is lender-paid mortgage insurance. Anyone can offer it to you, and most banks and direct lenders do offer it regularly, while most mortgage advisors working for brokers advise against it. Why is that?
It helps to understand how it works. You knew that the lender didn’t just make your mortgage insurance payments for you, right? So how do the insurance premiums get paid? Well, the mortgage insurance lender buys a policy and makes the payments, and then charges you for it, either in higher up-front costs or in the form of a higher interest rate. Let’s explore how this works:
Let’s say we have a $400,000 30 year fixed mortgage at 4.000%, 90% Loan-to-Value (LTV) ratio. We also assume a 720 FICO score, single family detached home, and a purchase transaction. (These factors all go into determining the cost of mortgage insurance.) Given these assumptions, our mortgage insurance should cost $146.67 per month.
But what if we want the lender to pay for it? A quick survey of a few leading lenders tells me that a lender would charge an extra 1.500 to 2.170 points up front for “lender-paid” mortgage insurance for this scenario. This translates to $6,000 to $8,680, or 41 to 59 months of insurance premium payments (at $146.67.)
So, if your choice is to pay $146.67 per month for 30 years or $6,000 to $8,680 up front, why wouldn’t you pay it up front? Well, you don’t have to keep your mortgage insurance forever. In every case (except FHA – another discussion) you can remove the insurance once you have at least 20 to 22% equity in the property, provided you’ve carried it for a minimum term which is defined in your contract. (2 years is most common, but longer terms are sometimes found.)
So, if two years from now you have enough equity, you could pay for an appraisal and petition the lender to remove the insurance – and then stop paying entirely. Then you’ve paid 24 monthly premiums over time plus an appraisal fee, rather than 41 to 59 months of premiums, up front.
Alternatively, you could absorb the cost in the interest rate, which would translate to a premium of 0.325% to 0.750% (depending on the day and the market) in the interest rate. Your mortgage payment would be between $87.48 and $176.93 higher than the same mortgage where you paid mortgage insurance separately. So, there is potential savings, or it could cost more every month. But again, now the premium is forever (in the form of the higher interest rate), whereas if you are paying a separate line item for the insurance you can eliminate it in 2 years or so.
Are there any other advantages to lender-paid MI then? It used to be that while interest paid on a mortgage was tax-deductible, mortgage insurance premiums were not. The Tax Relief and Health Care Act of 2006 changed that, at least for 2007. Congress has extended that deduction, however, every year through 2014 (so far). If this changes, which seems likely at some point, then lender-paid insurance paid for with a higher interest rate (rather than up-front points) will provide more of a tax deduction than borrower-paid mortgage insurance.
If you keep the loan for more than four or five years, however, that’s a high price to pay for the tax deduction. Plus, there are limitations on the deduction. For instance, if your income exceeds $109,000 (for 2014) you cannot deduct your mortgage insurance premiums, but you can still deduct your mortgage interest. (But that has limitations, too – see your tax advisor)
Lender-paid mortgage insurance can be an interesting strategy to use to save money on your mortgage. It is not, however, “new,” nor does the lender really pay for it. One way or another, you pay for the insurance policy that benefits your lender. But you knew that, didn’t you?