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Investment Finance: Lenders Mortgage Insurance

Is Lenders Mortgage Insurance Dead Money or a Valuable Tool?

I often speak with investors who do not how mortgage insurance can contribute to the creation of wealth - but you have to calculate he risks of low equity in times of extreme economic volatility.

Mortgage Insurance is a one off charge that is paid by property purchasers who borrow more than 80% of the purchase price. It is charged on a sliding scale, so for example if your loan to value ratio (LVR) is 84% you will pay less mortgage insurance than if you are borrowing 95%.

The amount charged can vary significantly from lender to lender, even given the same loan to value ratio, so it can pay to shop around. Premiums can vary from a few hundred to many thousands of dollars, depending on the amount borrowed and the LVR.

But what is mortgage insurance for, and who is the main beneficiary? 

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Because higher loan to value ratios are deemed to be more risky to the lender, once the LVR goes above 80%, LMI (Lender’s Mortgage Insurance) is payable. It protects the lender from losses incurred if the borrower defaults and the proceeds of the subsequent sale of the property are insufficient to cover the total amount owed.

For example, let’s say a borrower buys a property for $400,000. They put down a 5% deposit and borrow $380,000. A few months later they lose their job. They do not have income protection insurance and are unable to make the monthly repayments. The lender repossesses the property and sells the property for $370,000. They have made a loss of $10,000 plus accrued fees, charges and interest. Once they have received the net proceeds of the sale they would approach the mortgage insurer to make up the difference between the money they have realized from the sale and the total amount owed. The mortgage insurer would pay out to the lender, and would then no doubt pursue the borrower for reimbursement.

Many borrowers aim to avoid paying mortgage insurance, which they view as an impertinent impost by the lender, although in many cases it could be seen as having the effect of building an LVR safety margin into the transaction. They are forced to pay it even though the beneficiary in event of a future claim is the lender who made them pay it in the first place, yet they themselves receive no direct benefit.

There is however an alternative view.

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For some, it may be a valuable tool that gives them more leverage and enables them to growYou must carefull evaluate the risk with your financial advisor their asset base much quicker. Say you have $100,000 in cash or equity as a deposit. This is sufficient to fund a $400,000 purchase at 80% LVR ($80,000 deposit + $20,000 to cover stamp duty, legals etc). However if we take the LVR up to 90% we could possibly purchase two properties at $300,000 each. This would use up $90,000 and still leave us with a $10,000 buffer. We will need to pay some mortgage insurance, but the benefit is that we have a larger asset base. Instead of increasing our asset base by $400,000 we have increased it by $600,000. If in the first year of ownership If those properties go up by 10%, mortgage insurance has allowed you to invest in assets that have increased in value by an additional $20,000, more than enough to offset the cost of the initial premium.

On the hand, in a volatile economic climate 10% equity is not much of a buffer to protect you from a negative equity situation and the lender calling in your loan.

Summary.

Whilst mortgage insurance can at first glance appear to be a cheeky money grab by greedy lenders, the plain fact is that avoidance of LMI at all costs may sometimes be a false economy, and severely curb the acquisition of further growth assets. It may be just a cost of doing business. When lenders assess your capacity to borrow they look at your available funds to complete as well as your ability to make the repayments. Although mortgage insurance premiums can be quite steep, most investors would not have to pay the premium with cash – it can easily be ‘capitalized’ or added to the loan amount. For example, you may ask for an 85% LVR, but once the premium has been added in your end LVR could be 87%. So if you are one of those investors who have resented LMI in the past, take another look, it could prove to be a valuable tool that can help you achieve your goals much sooner than you thought - but do it carefully and wisely with assistance of your professional financial strategist.

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