Editor’s note: This is Part 1 of a two-part series.
I decided recently to take a look at private mortgage insurance (PMI) in the post-crisis market: how it differs from the pre-crisis market; the different payment options available to borrowers today, and how to choose between them; and why the PMI market is rigged against borrowers.
Crisis-induced market changes: The universal rule is that private mortgage insurance is required on conventional loans (those not insured or guaranteed by the federal government) whenever the borrower’s downpayment on a home purchase, or equity in the property on a refinance, is less than 20 percent.
This was also the rule before the crisis, but the rule was often violated in connection with subprime mortgages. Today, there are no such exceptions. Further, declines in property values since 2006 have eroded homeowner equity, making mortgage insurance mandatory in an increasing proportion of refinances.
PMI companies have suffered horrendous losses in recent years, in response to which they have increased their premiums, especially on riskier transactions, and tightened their eligibility requirements. For example, borrowers with credit scores below 660 are generally ineligible. The insurers, however, offer the same insurance premium payment options as before the crisis.
Mortgage insurance payment options: PMI companies offer numerous premium plans, but only three are worth considering. These are:
- Monthly premium: The borrower pays the same amount every month until the loan balance is paid down to 78-80 percent of the initial property value, at which point the payments cease.
- Single financed premium with rebates: The borrower makes one payment upfront, which is added to the loan amount, but receives a partial rebate if the loan is terminated within five years.
- Single financed premium without rebates: The same but there are no rebates.
The monthly premium plan is the most widely used by far, in large part because most borrowers don’t know they have other options. Why most borrowers are not aware of their options is discussed next week.
Relative premiums: I shopped premiums at the six PMI companies on a "plain vanilla" mortgage. It was a 30-year, fixed-rate, fully amortizing and fully documented mortgage used to purchase a single-family property in California as a primary residence by a borrower with a FICO score of 720 making a downpayment of 10 percent.
Since there were differences in the premiums quoted on this mortgage by the different PMI companies, I selected the most common premium for each of the three options. These were 0.62 percent/12 for the monthly premium, 2.2 percent for the single premium with rebates, and 1.4 percent for the single premium without rebates.
Impact on payments: The single-premium plans generate a much lower monthly payment increase than the monthly plan. For example, on a 30-year loan of $90,000 at 5 percent, the payment without insurance is $483.14, the monthly insurance premium is $46.50, and the total payment is $529.64.
The single financed premium with rebates increases the loan amount to $91,980, increasing the payment from $483.14 to $493.77. The single financed premium without rebates increases the loan amount to $91,260 and the payment to $489.91. In other words, the payment increase on this policy is $6.77 compared with $46.50 on the monthly premium policy.
But as I constantly remind borrowers, payments aren’t everything. The loan balance on the single-premium plans is larger when the loan is paid off, which increases its cost over the years the borrower has the policy. Unless the payment difference between the options significantly affects the borrower’s ability to afford the loan, the best premium plan is the one with the lowest total cost over the period the borrower expects to have the mortgage.
Factors affecting total cost: The total cost of the different options depends on how long the borrower expects to have the mortgage, how rapidly the property value appreciates, the borrower’s tax rate, whether or not the insurance premium is deductible, and the borrower’s investment rate — i.e., the interest loss on monies paid out. In general, a high expected appreciation rate and high tax rates when MI premiums are deductible favors the monthly premium, whereas a long expected mortgage life and high investment rate favor the single premium.
But borrowers should not rely on generalizations, because every transaction is different. Chuck Freedenberg and I developed a new calculator, number 14d on my website, that allows a user to find the cost of the different options in his or her particular case.
I used the calculator to test many different combinations of the factors discussed above, and found something interesting. In some cases the monthly premium policy had the lowest cost, and in other cases the single premium without rebates had the lowest cost, but in no case did the single premium with rebates have the lowest cost. It appears safe for borrowers to avoid this option, which seems to be overpriced.
Borrowers who are aware of the options can ask for premium quotes and test them using my calculator. If they don’t ask, it is very unlikely that the information will be volunteered. This suggests that there is something seriously amiss in the ways in which mortgage insurance is marketed and delivered, which is the subject of next week’s article.
