by Davey Edwards and Eric Kincheloe

If you haven’t formulated an opinion yet, it will not be long before you potentially have an emotional response to the idea of having a mortgage loan that carries some form of Mortgage Insurance ( MI ). MI by definition is an insurance policy that names the mortgage lender as the insured beneficiary in the event that the borrower defaults on the mortgage payments, resulting in foreclosure. 

In this two-part series we will dissect anything and everything that a home buyer needs to know about the world of MI—its history, how it works, benefits, disadvantages, how it is constantly changing, how to avoid it (sort of), and how to eliminate it.

HISTORY

For starters, you need to know when MI began and why. Prior to 1934, most consumers who wanted to purchase a home needed to find a way to come up with a 50% down payment. In 1934 the federal government recognized homeownership as a powerful catalyst to building the economy. The problem was that homeownership was out of reach for most Americans. Only four out of ten households owned homes. The result of this need to make homeownership more realistic was the Federal Housing Administration (FHA). FHA opened the way for many people by increasing the amount that they could borrow on a property. The tool by which this change happened was MI. The banks were still lending the money, but with MI, they had the federal government to protect them from the potential losses associated with lending at such a high percentage. 

Once the federal government opened the door, there was still great demand for more options. Because the early FHA mortgage programs were mired in red tape and required dramatically long processing times, the opportunity opened up for private companies to get involved. In 1957 a real estate lawyer named Max Karl founded Mortgage Guaranty Insurance Company, the first Private Mortgage Insurance (PMI) company. Today there are seven PMI companies, and along with FHA, in 2001 the nation’s homeownership rate surpassed 68%.

HOW MI WORKS

Now that you understand the when and why of the origins of mortgage insurance, you need to understand how MI works. 

Consumers are able or not able to borrow money based on risk, bottom line! As the risks associated with a loan increase, the consumer’s ability to borrow decreases. In lending, risks are measured by the three C’s, which are Credit, Collateral, and Capacity. 

Credit primarily deals with the likelihood of whether a borrower will pay based on his or her previous spending and payment history (Credit Report). 

Collateral focuses on the property being purchased and the amount of the loan against that property. 

Finally, Capacity is the borrower’s ability to repay the loan based on his or her verifiable income and amount of available assets. 

MI gives banks and lenders the ability to tolerate a higher level of risk because the mortgage insurance covers their losses in the event that the borrower does not repay. In part two we will cover the various types of MI and MI alternatives. For now, to understand how MI works, you need to know that there is a cost associated with this protection. As the risks increase, the costs typically increase as well. Someone pays for the insurance, and that is the borrower. There are options that call for someone else to pay the MI coverage, but at the end of the day the impact is felt by the consumer.

BENEFITS

The first benefit of mortgage insurance is by far the greatest, and that is that more families have the ability to buy a home. Before the world of PMI, a potential homeowner would have to put a full 20% down payment on a home, to receive financing. The other alternative was to find a bank that offered FHA programs and be buried in red tape. Today, MI allows qualifying borrowers the opportunity to buy that same property with zero dollars out of their pockets. In addition, even households that have funds to put down have the alternative to finance more and allow their funds to serve as a cash cushion or to fund other financial planning goals. 

Another benefit to MI is brand new to 2007. For this year only, there is a new itemized deduction for the cost of premiums for MI on qualified residences. The deduction starts to phase-out for taxpayers whose adjusted gross income exceeds $100,000.1 In 2006 one of the disadvantages to MI was the non-deductibility of the costs. We will see if this change becomes permanent in years to come.

This is a two-part series. In part two we will cover the disadvantages of MI, primarily relating to the costs; however, we will evaluate the various forms of MI and alternative loan programs that assist home buyers in reducing the cost.

Resources
http://www.hud.gov/offices/hsg/fhahistory.cfm
http://www.time.com/time/magazine/article/0,9171,877662-1,00.html

1 Matthew Tierinni,CPA is a partner with Montovani, Murray, Nemphos, & Tierinni in Manchester, CT, and can be reached at 860-643-1001 for tax-related questions.

Davey Edwards and Eric Kincheloe are certified mortgage planning specialists and managers for Primary Residential Mortgage Inc, in South Glastonbury, Connecticut. They can be reached at Davey@prmine.com and Eric@prmine.com or at 860-430-1845.