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 ou
