Lenders are willing to accept a lower down payment with loans backed by private mortgage insurance because they have less risk. If a PMI buyer defaults, the lender faces one of two choices, either of which is far more attractive than an uninsured foreclosure.
A PMI insurer may pay off the entire loan and thus gain title to the property. This happens in 30 to 40 percent of all PMI defaults.
Alternately, the insurer will pay 20 to 25 percent of the total claim. The "total claim" can include not only the outstanding mortgage balance but also such items as accrued interest, foreclosure costs, attorney's fees, and property tax payments made after the loan is in default.
It may seem that, with only 20 or 25 percent PMI coverage, the lender still would have considerable financial exposure, but this is not the case.
First, the original size of the loan was less than the sales value of the property. The difference between the loan amount and the selling price is represented by the purchaser's down payment.
Second, over time the buyer has paid down the original loan balance with each monthly payment, except in the case of negative amortization loans, where the value of the principal balance actually increases over time. As the principal balance declines, the proportion of the property's worth represented by the outstanding mortgage balance declines, as does the level of the lender's risk.
Third, there is the possibility that the value of the property has increased over time. Again, as the gap between the loan balance and the market value of the property is enlarged, the lender has less risk.
Fourth, the property has a foreclosure value that may be equal to or greater than the outstanding loan balance plus related costs. If the foreclosure value covers 100 percent of the money due to the lender, then the lender would have no claim against a private mortgage insurer. If the foreclosure value fell short of the amount of money due the lender, then the lender could make a claim against the insurer up to the value of the policy.
Although a private mortgage insurance premium is paid by the real estate purchaser, the lender is the beneficiary of the policy and determines whether it will be continued. This feature and several others make private mortgage insurance and the companies that offer such policies unique. Here's why:
* Although real estate buyers pay the premiums, private mortgage insurance agreements are actually contracts between lenders and insurers. A common provision of such agreements is that lenders must foreclose when monthly payments are four months behind.
* Private mortgage insurance premiums are established at the time a policy is issued and may not be changed.
* Private mortgage insurance may be cancelled only in the event of fraud or unpaid premiums.
* Private mortgage insurance is not sold through general insurance brokers. Instead, policies are marketed directly to lenders, who then make such policies available to borrowers as a condition of granting a loan. Lenders may not collect a sales commission for placing private mortgage insurance.
* PMI helps lenders resell loans in the secondary mortgage market, an important consideration for lenders who continually roll over funds to make new mortgages. Because of the substantial reserves private mortage insurers are required to maintain, PMI-backed loans are regarded as secure mortgage investments. Secondary lenders such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp., and private pension funds have bought millions of conventional loans backed with private mortgage insurance, mortgage purchases worth some $42.5 billion between 1974 and 1981 alone.
* Private mortgage insurers benefit from high inflation rates. The reason: Inflation reduces the worth of the dollar, and so it takes more cash dollars to acquire a given piece of real estate. Because mortages are valued in terms of cash dollars, it follows that mortgage insurers face fewer claims as property values rise, regardless of whether the increase in value is a product of inflation or real economic appreciation.
Private mortgage insurance is often mistaken for "mortgage life insurance," a different product. Mortgage life insurance is designed to protect purchasers if they are unable to pay their mortgage as a result of disability or death.
Mortgage life insurance is available through many lenders as well as general insurance agencies. Policies obtained through lenders normally name the lender as the beneficiary. For further information about costs and coverage, speak to both lenders and insurance brokers.
Questions to ask:
* What is the current premium for the first year of a private mortgage insurance policy and for each renewal year thereafter?
* If buying a multiyear policy, how many years of coverage will the lender require? What is the one-time cost of a multiyear private mortgage insurance policy? Can you add this expense to the mortgage amount you are seeking?
* What is the lender's general policy on renewing PMI mortgage coverage? How many years can you expect to pay a premium?
* As a condition of obtaining a mortgage, does the lender require the purchaser to place any money in an escrow account to assure that PMI premiums are paid? If so, how much? NEXT WEEK: Matters of negotiation
Peter G. Miller is a Washington area real estate broker.