What is mortgage insurance?
Lender Mortgage insurance, often referred to as LMI, is an insurance taken out by the lender to protect them against the borrower defaulting on their loan. It is a once off payment, paid by the borrower, when the loan is first taken out if the loan is above 80% of the value of the house eg. if the house was worth $400,000 then an 80% lend would be a $320,000 loan. Anything above 80% is considered a higher risk for the bank to lend against as there is less hurt money (equity) in the property if the borrower were to default.
As the loan to value ratio (LVR) gets higher (80% to 95%) the cost of the mortgage insurance premium increases as the risk increases. As a rule of thumb, the cost doubles from 80% to 85%, then doubles again to 90% and again to 95%.
95% is the maximum you can borrow against a house and the mortgage insurance cost can be over $10,000. It’s uncommon for first home buyers to avoid mortgage insurance all together but it’s not a bad thing. The following scenario shows that a borrower may be better off purchasing a house now with a smaller deposit and pay LMI, instead of saving a higher deposit to reduce the LMI cost.
John Smith wants to purchase his first home for $400,000. He has saved a $10,000 deposit over the last 4 years and is happy to use his $40,000 in full to purchase a house. Assuming house prices are increasing at 5% per year, if John purchased today and paid approx $15,000 in LMI, his house would be worth $20,000 more in a year’s time. This means John has made back his LMI cost in the first year.
Let’s now look at John’s second option, to wait another 2 years to save an extra $20,000 giving him $60,000 deposit for his house. Again, assuming house prices rose by 5% per year, this would mean John has $60,000 to purchase the same house that is now worth $441,000. Johns LMI cost now is approx $12,000. Only a small saving in LMI for all the effort of saving a further $20,000 over 2 years AND the bigger issue is John missed out on the increase in the house price of $41,000.
If you understand that it allows you to get into the property market with less money, Mortgage insurance is not something to be scared of.