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June 6, 2005 Revised October 5, 2005
"I recently was told about single file mortgage
insurance, which is supposedly superior to piggyback arrangements. Is it?"
Single File Mortgage
Insurance is Lender-Pay
Home purchasers who cannot make a down payment
of 20% today have three ways to go: traditional borrower-pay mortgage insurance;
second or "piggyback" mortgages; and lender-pay mortgage insurance. Single File
is MGIC�s name for its lender-pay program.
From a system perspective, lender-pay mortgage
insurance is the best option, and I look for it to prosper. That does not
necessarily mean, however, that a particular borrower might not find a better
deal with one of the other options, as I�ll explain later.
Drawbacks of
Traditional Mortgage Insurance
Under traditional mortgage insurance, the
borrower purchases the policy and pays the premiums, but the lender selects the
insurer. This is an odious arrangement, since it gives the lender referral power
and a preference for higher rather than lower premiums. Higher premiums permit
larger kickbacks to the lenders for the referral of business to the insurers.
While direct kickbacks are illegal under the
Real Estate Settlement Procedures Act (RESPA), there are numerous ways to
legitimize them. One that has become common among large lenders is to establish
a reinsurance affiliate that shares the premiums on insurance sold to the
lender�s customers. This is kosher under RESPA, since the affiliate also shares
the risk. The reality, however, is that reinsurance deals are disguised (and
costly) kickbacks.
Traditional mortgage insurance has another
unholy feature -- the insurance runs on well past the time that it is really
needed. Since the insurance protects the lender but the borrower pays for it,
the lender has no incentive to terminate the policy when the risk becomes
minimal. In 1999, Congress finally decided to do something about this,
establishing mandatory termination rules. The rules, however, are extremely
complex and difficult for borrowers to navigate.
Piggybacks as a
Substitute For Mortgage Insurance
Fortunately, there are a lot of lenders in our
system, and some of them have little stake in the traditional mortgage insurance
system. When they discovered a few years ago that they could obtain a
competitive advantage by offering combination first and second mortgages
instead, they jumped at it. For example, to the borrower who could only put 5%
down, they offered an 80% first mortgage plus a 15% second, in lieu of a 95%
first mortgage with mortgage insurance.
These came to be called "piggybacks". While the
second mortgage has a higher rate than the first, the higher rate is paid only
on the second mortgage and the interest is deductible. Premiums on traditional
mortgage insurance are paid on the entire first mortgage, and are not
deductible.
Within just a few years, piggybacks became
established as a major alternative to traditional mortgage insurance. With their
traditional business shrinking at an alarming rate, the insurers have been under
enormous pressure to develop counter-measures. Lender-pay insurance is the best
of them.
Advantages of
Lender-Pay Mortgage Insurance
Under lender-pay insurance, the lender pays the
premium and charges the borrower for it in the rate. This is better than
traditional mortgage insurance because lenders have an incentive to pay as
little as possible for the insurance, rather than to benefit as much as possible
from their referral power. Since lenders must compete in terms of interest rate,
the borrower ultimately will get the benefit of lower insurance premiums.
The rate increment lasts as long as the
mortgage, but that is also true of the second mortgage part of piggyback
arrangements. In addition, lender-pay insurance is simpler: one loan, one rate.
Piggybacks usually involve an incremental upfront fee, and the second mortgage
can be a different type of instrument than the first mortgage. Frequently, it is
an adjustable rate mortgage of some type, which makes the package more difficult
for borrowers to assess.
In my view, a system based on lender-pay
insurance will work better than one using traditional insurance or piggybacks.
This does not imply, however, that in our existing system that offers all three
choices, borrowers will always do better with lender-pay insurance.
Most loan providers charge what the market will
bear, which means that you can easily overpay for any of the options. Contrary
to what you may hear from a loan provider, there is no general answer to the
question of which approach is less costly to the borrower. There are only
specific answers to individual deals, and the answer can vary from deal to deal.
To help with this problem, I developed three calculators.
Calculator 13a compares the costs of a piggyback deal and lender-pay insurance. Calculator 14a compares the costs of traditional (borrower-pay)
insurance and lender-pay insurance. Calculator 14b compares the costs of all
three. Calculators are an excellent defense
against high-powered sales pitches.
Copyright Jack Guttentag 2005
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