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December 20, 1999
"I know that this
must be a na�ve question, but since mortgage insurance protects the
lender, why doesn't the lender pay for it?"
The question
is not na�ve.
Lenders require private mortgage
insurance (PMI) on mortgages with down payments less than 20% because the
risk of default and loss to the lender is greater on loans with smaller
down payments. The reason that the borrower pays for the coverage,
however, is more historical accident than anything else.
When the modern PMI industry began
in the late 1950s, many states had legal ceilings on interest rates. If
lenders paid for mortgage insurance and passed on the cost to borrowers as
a higher interest rate, they might have bumped up against those ceilings.
If the borrower paid the premium, this potential roadblock was avoided.
Unfortunately, a borrower-pay
system is much less effective than a lender-pay system. Borrowers do not
shop for mortgage insurance but are locked into arrangements established
by lenders, who decide the insurance carrier with which they want
to do business.
When the borrower pays, lenders
have little interest in minimizing insurance costs to the borrower because
these costs rarely influence a consumer's decision regarding the selection
of a lender. Insurers do not compete for the patronage of consumers, but
for the patronage of the lenders, who select them. Such competition is
directed not at premiums but at the services provided by the insurers to
the lenders. Its effect is to raise the costs to insurers, and ultimately
the cost borne by borrowers.
Under a lender-pay system, lenders
would shop for the lowest premiums. Because lenders buy in bulk, they
would have the market clout to push premiums down. (Even if borrowers
shopped for insurance, their single-policy purchases wouldn't give them
the same clout.) As a result, the higher interest rates under a lender-pay
system would be lower than the combined cost of interest plus insurance
premiums under the current borrower-pay system.
A lender-pay system also would
eliminate confusion over when insurance can be terminated. Under the
existing system, until very recently, the borrower could terminate
insurance only with the permission of the lender. The lender, however, had
no financial incentive to agree other than to please the borrower. Some
lenders allowed PMI termination under certain specified conditions. Others
had more stringent conditions. Still others did not allow it at all. Many
borrowers, furthermore, were unaware of the possibility of terminating
insurance, and paid premiums for years longer than necessary.
Recently the Congress along with
the two Federal agencies that buy mortgages in the secondary market
(Fannie Mae and Freddie Mac) have tried to deal with this problem by
setting out
conditions under which lenders were required to terminate mortgage
insurance. Unfortunately, these well-intentioned efforts have
created an enormously complicated set of termination rules. The rules
differ for borrowers who have closed their loans since July 29, 1999 and
those who closed before that date, and they differ for borrowers whose
loans were sold to one of the Federal agencies and other borrowers.
In addition, some states have PMI termination laws with effective
dates that precede the federal law's effective date. My mail box is
stuffed with letters from consumers who are confused by these rules.
It is all unnecessary.
If lenders paid for mortgage
insurance, they would decide when to terminate it, based on whether
or not they felt the insurance was still needed. Some lenders would
probably reward borrowers after terminating the insurance. Borrowers could
choose between two-tier rate plans and single-rate plans. The rules would
be set in the market rather than by government.
The one rule needed from the
government is that lenders must purchase mortgage insurance.
Copyright Jack Guttentag
2002
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