November 6, 2000, Revised December 12, 2007

Because borrowers pay for mortgage insurance that protects the lender, much of the responsibility for terminating the insurance when it is no longer needed falls on the borrower. Unfortunately, the termination rules are unavoidably complicated.

Borrower-Pay Mortgage Insurance Requires Termination Rules

The insured party in a mortgage insurance transaction is the lender. Therefore, they should pay the premium and pass on the cost in the interest rate. If lenders paid the premiums, they would decide when to terminate individual loans, based on whether they believed the risk remaining in the mortgage justified continued payment of the premium. If the premium was a one-time payment, no such decision would have to be made. In either case, borrowers would be out of it.

Some mortgage insurance is indeed lender-pay, and borrowers are not bothered with complicated termination rules because they are not involved. See Single File Mortgage Insurance: An Advance? But most policies remain borrower-pay.

When mortgage insurance premiums are paid by borrowers, lenders have no financial incentive to terminate. Since lenders are protected by the insurance but don’t pay for it, they have no reason to terminate voluntarily. Borrowers are required to purchase insurance when they don't have 20% equity in their home, but they may find themselves still paying premiums when their equity is much higher than that. Lenders must be forced to terminate by government. And that’s where the trouble starts.

Why Mortgage Insurance Termination Rules Are Complicated

Governments begin with the principle that since borrowers are not required to buy mortgage insurance if they put 20% down or more, the insurance ought to terminate when their equity rises to 20%.

For example, a home buyer who borrows $95,000 to purchase a $100,000 home is putting only 5% down and must purchase mortgage insurance. But when that borrower has paid down the loan balance to $80,000, the insurance ought to terminate. That seems simple and fair.

It also seems fair to terminate if part of the increase in the owner’s equity is a result of appreciation in market value. For example, the borrower would have 20% equity if the property value rose to $110,000 while the loan balance was reduced to $88,000.

But suppose virtually all the increase in equity resulted from appreciation within just a few months after purchase? In areas where prices jump sharply, they can also drop sharply, which suggests that there be some minimum period for retaining the insurance.

Termination rules also must take account of other developments that may affect the lender’s risk. For example, it wouldn’t be fair to the lender to require termination if the borrower has been chronically late on his payments, has taken out a second mortgage, or has moved out and is renting the house.

A major issue in government-mandated termination rules is where responsibility lies for initiating termination? Lenders can be made responsible if termination is based on the current loan balance and the original property value, because the lender has that information. But lenders can’t be made responsible for termination based on the current property value, because they don’t have that information and it would be inordinately costly to maintain it for every borrower.

There is no alternative to making borrowers responsible for initiating termination based on current market value. They know better than the lender what their property may be worth.

But how do borrowers become aware of the rules and procedures to follow in initiating the termination process? For example, what must the borrower do to establish the current value?

Government requires lenders to disclose the rules and procedures at the time the loan is made. So borrowers already suffering from information overload at the closing table, get one more set of disclosures that they cannot absorb.

Multiple Government Entities Make it Worse

Congress in the Homeowners Protection Act of 1998 set out ground rules for termination of private mortgage insurance on all mortgages originated after July 29, 1999. Loans originated prior to that date might be covered by state law. Ten states, including California and New York earlier had passed similar legislation.

Following the Federal legislation, Fannie Mae and Freddie Mac, both US Government-sponsored enterprise, established their own termination rules for the mortgages it purchases from lenders. These are more liberal, but available only to borrowers whose loans were purchased by the agencies.

For my attempt to guide borrowers through this labyrinth, see Canceling Private Mortgage Insurance (2).

Termination rules for mortgage insurance provided by the Federal Housing Administration (FHA) are completely different than those applicable to private mortgage insurance, and are based on earlier Federal legislation and regulations of the FHA. See Cancelling FHA Insurance.

Borrowers paying for private mortgage insurance who have 20% equity in their properties may be able to terminate at their own initiative. The specifics of who can and who can’t are very complicated and will be sorted out in another column. It will not apply to FHA borrowers, who require a column of their own.