How buying lenders mortgage insurance can allow you to grow your property assets faster
I often speak with investors, and the question about how much deposit should they put into a property purchase and how much cash they should keep as a buffer often comes up in the discussions. What many investors fail to realise is the contribution that mortgage insurance can make to the creation of wealth. Most just see it as another expense.
So what is mortgage insurance and why and when should you consider using it?
Mortgage insurance is a one-off charge that is paid by the property purchasers who borrow more than 80% of the purchase price in the case of full-doc loans and 60% in many cases on low-doc loans.
It can be the valuable tool that can help you achieve your goals much sooner.
Consider the comment I often hear from property investors: “Why would you want to incur an extra cost?” As a result most try to avoid paying mortgage insurance, which they view as an impost by the lender.
What some investors fail to recognise is that in some instance it can be a very valuable tool that gives them more leverage and enables them to grow their asset base faster.
For example, two investors have the same $100,000 to use a deposit but each approaches mortgage insurance slightly differently:
Investor one wants to avoid paying mortgage insurance and takes a conservative approach purchasing a property for $400,000. With a loan at an 80% LVR or $320,000 the $100,000 covers the 20% or $80,000 deposit + $20,000 to cover stamp duty, legals, etc.
Investor two take a different approach and is happy to gear up to 90% and pay the mortgage insurance costs. This allows for the purchase of two properties at $300,000 each. Now the $100,000 deposit covers the 10% or $60,000 deposit + $30,000 to cover stamp duty, legal etc, and leaves the investor a buffer of $10,000 in cash. To be fair it has cost 1.22% of the loan amount of $540,000 or $6,588 in mortgage insurance to secure the extra funds. This is explained in the table below.
However, if in the first year of ownership those properties go up by 5% the mortgage insurance has allowed the investor to purchase an additional $200,000 in property that has now increased in value by an additional $10,000, which is more than enough to offset the cost of the initial premium.
So how does lenders mortgage insurance (LMI) work? Firstly is should not be mistaken for mortgage protection Insurance, which covers the loan repayments on your mortgage in the event of death, sickness, unemployment or disability. LMI protects the lender against a loss should you default on your loan. For example if the security property is required to be sold as a result of the default, the net proceeds of the sale may not always cover the full balance outstanding on the loan. In this case, the lender is entitled to make an insurance claim for the reimbursement of any shortfall, calculated in accordance with the terms of the insurance policy. The mortgage insurance companies will then generally pursue the borrower to recover these funds.
With a normal 80% lend, it is fairly unlikely that there will be shortfall after the sale of the property and as a result most lenders will take on this risk. However as the loan-to-value ratio (LVR) rises, the borrower is required to contribute less deposit. The possibility of the property being sold at mortgagee sale and the proceeds not being enough to cover the loan also rises. As a result the lenders look to avoid this risk by insuring the loan against this possibility.
As the risk is now taken by the Mortgage Insurance company they also look to match the insurance premium to the level of risk. As a result mortgage insurance is charged on a sliding scale so for example if your loan to value ratio (LVR) is 84% you will pay less mortgage insurance than if you are borrowing 95%.
For example on a $300,000 loan you could expect something like the following scale.
LVR Band | Premium as a percentage | Approximate Cost |
80.01% to 82% | 0.41% | $1,230 |
82.01% to 84% | 0.61% | $1,830 |
86.01% to 88% | 0.91% | $2,730 |
88.01% to 90% | 1.22% | $3,660 |
90.01% to 92% | 1.68% | $5,040 |
92.01% to 94% | 1.89% | $5,670 |
94.01% to 95% | 2.10% | $6,300 |
Also because the frequency of defaults can vary depending on the lender it is also worth noting that the amount charged can vary significantly from lender to lender, even given the same loan-to-value ratio, so it can pay to shop around.
Some lenders also pay a part of the mortgage insurance costs to a point and some, like Westpac, CBA and ING, have their own mortgage insurance for some loans. Some lenders even switch between mortgage insurers depending on who has the lower cost premium. So if you are going to go down this track it is important to speak with your mortgage broker about which lender is best for you circumstance.
So while at first glance mortgage insurance can appear to be an unnecessary expense charged by the lenders. The plain fact is that avoidance of LMI at all costs can be a false economy, which ultimately curbs the acquisition of further growth assets. If you are truly treating your property investing as a business it can be seen as just another cost of doing business. So if you are one of those investors who have resented LMI in the past, take another look. It could prove to be a valuable tool that can help you achieve your goals much sooner than you thought.
Albertus Waldron is finance strategist and partner at Chan & Naylor