If a borrower has less than 20% deposit to put towards their property, and they are a) willing to pay the Lenders Mortgage Insurance premium, and b) meet the Lenders Mortgage Insurance criteria; the bank or lender are then able to offer the borrower a loan of up to 95% of the value of the property they wish to purchase.
Lender’s Mortgage Insurance is commonly mistaken as a type of insurance that protects the borrower so it is important to understand that it does not protect the borrower, it protects the bank or lending institution.
As the property market fluctuates, the bank considers it a higher risk to lend a client more than 80% of the value of their property (just in case property prices go down in value!). So, they look to obtain insurance coverage on loans where the borrower wishes to borrow in excess of this. They approach a Lenders Mortgage Insurer who will assess the borrower’s circumstances and if they meet criteria the Lenders Mortgage Insurer will approve the cover. They charge a one-off insurance premium which is payable by the borrower (not the bank!).
The Lenders Mortgage Insurance policy or coverage then protects the bank in the event the borrower fails to meet their mortgage repayments and the bank has to sell the property and there is a shortfall between the property sale price and the remaining/outstanding mortgage.
As an example. Harry may buy a property for $500,000 and he borrows 95% of its value being $475,000. One year later Harry has an accident out playing sport on the weekend and has no income protection insurance so fails to meet his mortgage repayments on the loan for over 3 months. As per their rights, the bank then take action to sell the property to recover their loan. They sell the property for $470,000. They need to pay a real estate agent commission of $10,000 from this meaning they are left with $460,000. The balance of the bank loan is $480,000 (remember Harry was in arrears by 3 months meaning his interest was accruing) So the bank has $460,000 in net sale proceeds but their loan is $480,000 which means there is a shortfall of $20,000 owing to the bank. The bank can then claim this shortfall from the lenders mortgage insurer.
A lenders mortgage insurance premium is between 2-3% of the loan amount. So, it is quite a hefty premium, however in 90% of cases the premium can be added to your loan. So, if you are buying for $500,000 and want to borrow 95% ($475,000) your lenders mortgage insurance premium would be around $14,000. The lender (in most cases) will add this $14,000 to your $475,000 loan meaning the total amount they lend you will be around $489,000. Yes, this means you are in effect “borrowing” the lenders mortgage insurance premium and paying interest on it over the term of your loan.
We see many clients who would read the above and be adamant that lenders mortgage insurance is a “waste of money” and are adamant they don’t want to pay it and would prefer to wait to save a 20% deposit. However, let’s look at it from another perspective…
It is fact that property prices increase on average around 6% in value per annum. If you are looking to purchase for $500,000, the difference between putting in a 5% deposit or a 20% deposit is a huge $75,000. If you were saving $500 per week, it would take you 3 years to save an additional $75,000 to avoid paying lenders mortgage insurance.
6% capital growth on a property worth $500,000 is approximately $30,000 per annum. So, you could pay the $14,000 lenders mortgage insurance premium upfront, or wait 3 years and pay about $90,000 more for the property you want to buy. It’s really quite a simple equation if you ask me!
* Please note I have not factored in interest on the $14,000 lenders mortgage insurance premium nor have I used compound capital growth. Both would alter the figures slightly however the outcome would be similar. Have kept it very simple for the purpose of this exercise