Why Do Borrowers Pay For Mortgage Insurance?
December 20, 1999, Revised November 29, 2007
Borrowers pay for mortgage insurance because when the modern industry began in the 1950s, legal interest rate ceilings would have prevented lenders from paying the premiums and passing on the cost to borrowers in the rate. The borrower-pay system, however, has created numerous problems, including perverse competition where insurers compete for the favor of lenders, raising costs to borrowers. It also has created a thorny issue on how and when mortgage insurance can be terminated.
"I know that this must be a naïve question, but since mortgage insurance protects the lender, why doesn't the lender pay for it?"
The question is not naïve.
Lenders require private mortgage insurance (PMI) on mortgages with down payments less than 20% because the risk of default and loss to the lender is greater on loans with smaller down payments. The reason that the borrower pays for the coverage, however, is more historical accident than anything else.
When the modern PMI industry began in the late 1950s, many states had legal ceilings on interest rates. 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 rarely 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. See Is Mortgage Insurance Overpriced?
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. (Even if borrowers shopped for insurance, their single-policy purchases wouldn't give them the same clout.) As a result, the higher interest rates under a lender-pay system should be lower than the combined cost of interest plus insurance premiums under the current borrower-pay system.
A lender-pay system also would eliminate confusion over when insurance can be terminated. Under the existing system, until very recently, the borrower could terminate insurance only with the permission of the lender. The lender, however, had no financial incentive to agree other than to please the borrower. 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.
In 1999, the Congress along with the two Federal agencies that buy mortgages in the secondary market (Fannie Mae and Freddie Mac) tried to deal with the termination problem by setting out conditions under which lenders were required to terminate mortgage insurance. Unfortunately, these well-intentioned efforts have created an enormously complicated set of termination rules. See Cancelling Private Mortgage Insurance (1) and Cancelling Private Mortgage Insurance (2).
The rules differ for borrowers who have closed their loans since July 29, 1999 and those who closed before that date, and they differ for borrowers whose loans were sold to one of the Federal agencies and other borrowers. In addition, some states have PMI termination laws with effective dates that precede the federal law's effective date. My mail box is stuffed with letters from consumers who are confused by these rules.
It is all unnecessary.
If lenders paid for mortgage insurance, they would decide when to terminate it, based on whether or not they felt the insurance was still needed. Some lenders would probably reward borrowers after terminating the insurance. Borrowers could choose between two-tier rate plans and single-rate plans. The rules would be set in the market rather than by government.
When this article was revised in 2007, lender-pay systems had been introduced, including the Single File system from MGIC. See Single File Mortgage Insurance: An Advance?
Borrowers pay for mortgage insurance because when the modern industry began in the 1950s, legal interest rate ceilings would have prevented lenders from paying the premiums and passing on the cost to borrowers in the rate. The borrower-pay system, however, has created numerous problems, including perverse competition where insurers compete for the favor of lenders, raising costs to borrowers. It also has created a thorny issue on how and when mortgage insurance can be terminated.
"I know that this must be a naïve question, but since mortgage insurance protects the lender, why doesn't the lender pay for it?"
The question is not naïve.
Why Borrowers Pay For Mortgage Insurance
Lenders require private mortgage insurance (PMI) on mortgages with down payments less than 20% because the risk of default and loss to the lender is greater on loans with smaller down payments. The reason that the borrower pays for the coverage, however, is more historical accident than anything else.
When the modern PMI industry began in the late 1950s, many states had legal ceilings on interest rates. 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.
Borrower-Pay Raises Costs to Borrowers
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 rarely 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. See Is Mortgage Insurance Overpriced?
Advantages of a Lender-Pay System
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. (Even if borrowers shopped for insurance, their single-policy purchases wouldn't give them the same clout.) As a result, the higher interest rates under a lender-pay system should be lower than the combined cost of interest plus insurance premiums under the current borrower-pay system.
A lender-pay system also would eliminate confusion over when insurance can be terminated. Under the existing system, until very recently, the borrower could terminate insurance only with the permission of the lender. The lender, however, had no financial incentive to agree other than to please the borrower. 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.
In 1999, the Congress along with the two Federal agencies that buy mortgages in the secondary market (Fannie Mae and Freddie Mac) tried to deal with the termination problem by setting out conditions under which lenders were required to terminate mortgage insurance. Unfortunately, these well-intentioned efforts have created an enormously complicated set of termination rules. See Cancelling Private Mortgage Insurance (1) and Cancelling Private Mortgage Insurance (2).
The rules differ for borrowers who have closed their loans since July 29, 1999 and those who closed before that date, and they differ for borrowers whose loans were sold to one of the Federal agencies and other borrowers. In addition, some states have PMI termination laws with effective dates that precede the federal law's effective date. My mail box is stuffed with letters from consumers who are confused by these rules.
It is all unnecessary.
If lenders paid for mortgage insurance, they would decide when to terminate it, based on whether or not they felt the insurance was still needed. Some lenders would probably reward borrowers after terminating the insurance. Borrowers could choose between two-tier rate plans and single-rate plans. The rules would be set in the market rather than by government.
When this article was revised in 2007, lender-pay systems had been introduced, including the Single File system from MGIC. See Single File Mortgage Insurance: An Advance?