Mortgage insurance provided by private mortgage insurance
companies (PMIs). As distinguished from mortgage insurance provided by the government under FHA and
VA. Insurance Premiums: Premiums are most often quoted as annual rates that are paid monthly. Some
typical premium rates are shown below. They vary by type of mortgage, down payment, and term. In the
future, it is likely that insurance premiums will be tied to other transaction features that affect
risk. The Cost of PMI: PMI is useful to borrowers because it allows loans that exceed 80% of value.
So does a second mortgage. If you wanted to compare the two, the cost of PMI should be measured on
the portion of the loan that exceeds 80% of value. For example, assume you can obtain a 15-year fixed
rate mortgage at 7.5% and zero points to purchase a $100,000 house. Without mortgage insurance, you
could borrow up to $80,000, whereas with mortgage insurance you could borrow up to $95,000 (95% of
property value). The insurance premium on the $95,000 loan is .79% of the balance per year for the
first 10 years, after which it drops to .20%.
The loan of $95,000 consists of two loans: one for $80,000 which has an interest cost of 7.5%
consisting solely of the interest rate, and one for $15,000, the cost of which includes both the
interest rate and the insurance premium. The interest cost on the $15,000 loan turns out to be 12.7%
if you stay in your house for up to 10 years, declining slowly after that to 12% if you stay a full
15 years. Since the insurance premium is only .79%, how can the cost of the $15,000 loan be 5.2%
higher than the cost of the $80,000 loan? The reason is that while you are borrowing an additional
$15,000, you pay the premium on the entire $95,000. The cost calculation above assumes that you take
a fixed-rate mortgage with a loan-to-value ratio of 95% and pay mortgage insurance for 10 years.
Change the assumptions and you change the cost. Why Aren't PMI Premiums Deductible? The IRS says that
mortgage insurance premiums are not deductible. In this, they are inconsistent.
Interest payments on home mortgages are deductible, and no distinction is made by the IRS between the
portion of the interest payment that represents compensation for the time value of money and the
portion that represents compensation for risk. If a low-risk borrower pays 7%, for example, while a
high-risk borrower pays 9%, the entire interest payment of the high-risk borrower is deductible.
However, if the lender charges both borrowers 7% but requires that the high-risk borrower purchase
mortgage insurance, with the mortgage insurer now collecting the 2% or its equivalent, the IRS will
not allow the 2% to be deducted. That is inconsistent. The IRS classifies mortgage insurance premiums
as payments by borrowers for services provided by the lender, similar to an appraisal fee, and as a
general matter such payments are not deductible. The problem with this position is that the lender is
not in fact providing any service in connection with mortgage insurance. The mortgage insurance
premium is a payment for risk, in exactly the same way that the 2% rate increment charged the
high-risk borrower is a payment for risk. Apart from possible differences in price, the borrower
doesn't care whether the lender receives the payment and takes the risk or the mortgage insurance
company receives the payment and takes the risk. Why Do Borrowers Pay the Premiums? If lenders paid
for mortgage insurance and passed on the cost to borrowers as a higher interest rate, they might have
bumped up against those ceilings. If the borrower paid the premium, this potential roadblock was
avoided. Unfortunately, a borrower-pay system is much less effective than a lender-pay system.
Borrowers do not shop for mortgage insurance but are locked into arrangements established by lenders,
who decide the insurance carrier with which they want to do business.
When the borrower pays, lenders have little interest in minimizing insurance costs to the borrower
because these costs do not influence a consumer's decision regarding the selection of a lender.
Insurers do not compete for the patronage of consumers, but for the patronage of the lenders who
select them. Such competition is directed not at premiums but at the services provided by the
insurers to the lenders. Its effect is to raise the costs to insurers and ultimately the cost borne
by borrowers. Under a lender-pay system, lenders would shop for the lowest premiums. Because lenders
buy in bulk, they would have the market clout to push premiums down. As a result, the higher interest
rates under a lender-pay system would be lower than the combined cost of interest plus insurance
premiums under the current borrower-pay system. Furthermore, the rate increase that the lender tacks
on to cover the cost of insurance is deductible to the borrower, where a mortgage insurance premium
paid by the borrower is not. A lender-pay system also would eliminate confusion over when insurance
can be terminated, as noted below. Terminating PMI: Until 1999, borrowers could terminate PMI only
with the permission of the lender. Because borrowers paid the premiums, however, lenders had no
financial incentive to agree. Some lenders allowed PMI termination under certain specified
conditions. Others had more stringent conditions. Still others did not allow it at all. Many
borrowers, furthermore, were unaware of the possibility of terminating insurance and paid premiums
for years longer than necessary. What Congress should have done to deal with this problem was mandate
that lenders pay PMI premiums. If lenders paid for mortgage insurance and passed on the cost in the
interest rate, lenders would decide when to terminate based on whether or not they felt the insurance
was still needed. This would also have reduced the cost of PMI, for reasons indicated above. Instead,
Congress in 1999 elected to do it the hard way, by enacting mandatory termination rules.
Unfortunately, the rules are unavoidably complicated. Under federal law, lenders are required to
cancel PMI on loans made after July 29, 1999, when amortization has reduced the loan balance to 78%
of the value of the property at the time the loan was made. Cancellation is automatic. Loans made
before July 29, 1999, are not covered by the law. In addition, under the 1999 law, lenders must
terminate insurance at the borrower's request when the loan balance hits 80% of the original value.
Borrowers who take the initiative can thus terminate earlier than those who wait. However, the lender
need not comply if the property has a second mortgage or has declined in value. Furthermore, the
borrower cannot have had a payment late by 30 days or more within the year preceding the cancellation
date, or late by 60 days or more in the year before that. Loans sold to Fannie Mae or Freddie Mac,
however, are subject to the termination rules of the agencies regardless of when the loan was made.
And these rules are more favorable to homeowners because they are based on the current appraised
value of the property rather than the value at the time the loan was made. Under the rules of the
agencies: Borrowers can terminate after two years if the loan balance is no more than 75% of current
appraised value, and after five years if it is no more than 80%. Borrowers must request cancellation
and obtain an appraisal acceptable to the agencies and to the lender. The ratios required for
termination are lower if there is a second mortgage, if the property is held for investment rather
than occupancy, or if the property is other than single-family. The agencies will not accept
termination if a payment has been 30 days late within the prior year or 60 days late in the year