Friday, April 2, 2010

The What and Why of PMI

In years past if you wanted to buy a home a down payment of at least 20% was required. It was simple; if you needed long term financing for the home, the bank required that you have a considerable amount of “skin in the game”. They would finance the difference, but you had to put down the 20%.

The President was Jimmy Carter, the year was 1977, and the Community Reinvestment Act (CRA) was made law by the congress. The CRA required all financial institutions receiving FDIC Insurance be evaluated by Federal banking agencies to determine if these institutions were extending credit to all communities in which they were chartered to do business. This act sought to address discrimination in loans made to individuals and businesses in low and moderate income neighborhoods.

Implementing this law proved challenging and potentially more risky. Lenders knew that credit extended to lesser qualified borrowers had a higher possibility of default. At the same time, creditors realized that extending credit for these loans not only provided much needed capital for some communities, it could also prove to be a source of new profitable business. But lenders had to find a way to minimize or even cover the increased risk on these loans. And thus, Private Mortgage Insurance (MI) was born.

MI is offered by a business providing a financial guaranty to a lender extending mortgage credit to a borrower who has less than 20% to put down on a home purchase. The MI business in effect assumes a portion of the lender’s risk in making that mortgage loan. For sharing the risk, the MI company collects a premium from the lender and the lender typically recovers these costs from the borrower. The risk for the MI company is that the borrower will default on the loan and the insurer having to pay a claim to the lender.

Here’s an example of how it works.

Anita Lohn is buying a home for $150,000 and she has a 10% down payment, or $15,000. Her lender acquires an MI policy on her remaining $135,000 mortgage reducing its exposure to loss from $135,000 to about $101,000. Mortgage Insurance typically covers the top 25% to 30% of the mortgage. In Anita’s case, the MI will absorb approximately 25% of her remaining mortgage.

FHA home loans have their own Federally backed mortgage insurance. These loans benefit home buyers in two ways. First, the required down payment of 3.5% of the purchase price is less than required on conventional loans. And the monthly mortgage insurance premium is also reduced. At the same time, most FHA loans require an up front mortgage insurance premium that the borrower has the option of either paying at the time of closing, or rolling into the total loan amount. As of April 5, 2010 this up front mortgage insurance premium will be 2.25% of the home’s purchase price. Borrower’s should be made aware that FHA mortgage insurance is scheduled to last a minimum of 5 years, regardless if the home owner pays the loan balance down below 80% of the home’s value.

There are two common confusions about MI. First, mortgage insurance is not the same as property and casualty insurance. The property insurance covers the home owner’s risk to fire and other damage to their home. MI provides no such coverage. Second, MI is not the same as mortgage life insurance. This type of insurance covers the balance remaining on the mortgage when the insured home owner dies or becomes disabled. MI covers the lender’s risk, and the home owner gets to pay for it.

Private mortgage insurance makes it possible for families to buy homes with minimal down payments. For first time home buyers, MI helps them clear the hurdle of a large 20% down payment. In most cases the costs associated with MI are tax deductible at least through 2010. Households with adjusted gross income of $100,000 or less may deduct 100% of these costs. It’s best to consult your tax accountant for the full details on deducting MI costs.