Last week I published an article on how home mortgage
borrowers who were required to purchase mortgage insurance
could earn a high rate of return by paying it off – with the
help of a new spreadsheet now on my web site. See
For a Safe Investment With a High Yield? Pay Off Your
Mortgage Insurance. That article ignored what would have
been the first question posed by a smart visitor from Mars:
why does the borrower pay for insurance that protects the
I will return to that question below, but as a backdrop to it, readers should understand why that question is important. It is important because a system, in which lenders paid for mortgage insurance, with the cost included in the price of the mortgage, would be substantially less costly to borrowers than the current system in which the borrower pays directly.
Borrower-Pay Is Excessively Costly
For one thing,
lenders receiving insurance protection paid for by borrowers
have zero incentive to terminate it. On the contrary, their
interest is in keeping it in force because it reduces their
risk and costs them nothing. Keeping it in force also
generates more revenue for the insurer, with whom they
probably have a long-term relationship.
of borrower-paid insurance was the motivation for the
legislation enacted in 1999 that allowed borrowers with
private mortgage insurance to terminate it when certain
milestones were reached. However, the rules regarding
termination are complicated and the costs of the process to
both borrowers and lenders are significant – even with my
reason borrower-pay is excessively costly is that premiums
are not subject to competitive pressures. Borrowers purchase
insurance from the insurer designated by the lender, which
means they have no market power. Lenders have market power
because they select the insurer and refer multiple loans,
but they have no incentive to use their power to reduce
premiums because they do not pay the premiums.
Lender-Pay Would Reduce Costs
lender-pay system, the cost of mortgage insurance would be
included in the price of the mortgage paid by the borrower.
The incremental cost to the borrower, however, would be far
smaller than the PMI premiums they pay today. Lenders would
keep insurance in place for shorter periods, and premiums
would be lower.
lender-pay system, insurance would be in force for shorter
periods because lenders would deploy automated systems that
would flag when the risk had declined to the point where it
no longer justified the premium payment. These systems would
be much more effective than the clumsy rules legislated in
1999 under which borrowers were given the right to terminate
be lower in a lender-pay system because lenders would have
the incentive to minimize them, and the market muscle --
associated with the capacity to place many policies -- to
bargain them down. The borrower would not be involved at all
-- what a blessing!
I should note
that, with minor modifications, the arguments advanced above
apply as well to lender’s title insurance, which also
protects the lender and is paid for by the borrower.
have difficulty with these conjectures might ask themselves
the following question: “What would happen to the total
price of an automobile if it were sold without tires or
batteries, which had to be purchased separately from dealers
specified by the automobile agency?”
Why Do We
Have a Borrower-Pay System?
A system where
borrowers pay for insurance that protects lenders is
dysfunctional, and it is also unusual. The general rule is
that the party who benefits from insurance also pays for it.
How did this dysfunctional practice happen?
borrower–pay feature of mortgage insurance was adopted by
the newly emerging PMI industry in the late 1950s, following
the model of FHA, which was chartered in 1934. FHA adopted
borrower-pay because it was subject to legal interest rate
ceilings, which were pervasive at that time. It would have
been very difficult to sell insurance protection to lenders
if the lenders had to pay the premiums while their ability
to pass on the cost in the interest rate was limited by a
regulation, a good rule is one that makes the market work
better and a bad rule is one that makes the market
dysfunctional. Interest rate ceilings are bad rules. FHA
remained subject to rate ceilings until 1983, when they were
finally removed following several episodes of market
disruption when market rates hit the ceiling.
The removal of mortgage interest rate ceilings eliminated such episodes, but the other dysfunctional effect of rate ceilings – the dysfunctional practice of having borrowers pay for insurance that protects the lender -- lingered on after the ceilings were removed. The 1999 rule that granted borrowers the right to terminate insurance once a complex set of conditions has been satisfied, was an attempt to soften the worst features of borrower-pay insurance. A much simpler and more effective rule would have required lenders to pay for mortgage insurance.