Posted In:
MENUMENU
One word you’ll often hear when working with mortgage lenders is “risk.” Lending hundreds of thousands of dollars to individuals so they can purchase homes is indeed risky. While most people repay their debt, there’s always a chance that something could go wrong and keep borrowers from making payments.
Despite the current mortgage default rate in the U.S. being at an all-time low of less than 4%, banks are still responsible for implementing risk mitigation strategies to protect their interests. Although taking out a mortgage can feel arduous to a home buyer, from the lender’s perspective, they must perform due diligence to minimize risks and only lend to responsible individuals with the means to repay the loan.
However, even after the underwriting process and closing, banks naturally want to protect their interests and reduce the likelihood of loss. Requiring borrowers to carry homeowners insurance is one risk reduction strategy.
Legally, homeowners do not have to carry a home insurance policy. It’s not a requirement in any state or at the federal level.
However, if you have a mortgage on your home, there’s a good chance that your bank or mortgage lender requires this coverage. Depending on the lender, you may need to carry enough insurance to rebuild the home in the event of a total loss, or you might only need a policy to cover the loan amount. This requirement is in place to protect the lender if something happens to the property that renders it uninhabitable, like a fire or wind storm.
Essentially, a homeowners insurance policy provides a safety net for the homeowner and the lender in the event of a catastrophe. Even if the property is a total loss, homeowners must pay the mortgage. With insurance, they can rebuild their home or pay off the balance of their home loan, and the lender doesn’t lose any money.
If your lender requires you to have homeowners insurance, and you cancel your policy or allow it to lapse, the lender has the right to purchase a policy on your behalf, called a force-placed policy. These policies protect the interests of the lender.
Canceling your insurance policy isn’t the only thing that can trigger a force-placed policy. Your lender may purchase such a policy under any of the following conditions:
Because the purpose of a force-placed policy is risk mitigation for the lender, it isn’t the best option for homeowners. For starters, most such policies only cover the balance of the mortgage, although some lenders offer the option for homeowners to select replacement coverage on a force-placed policy.
Regardless of the amount of coverage you select, a force-placed policy is more expensive than standard homeowners insurance. Insurers charge more for these products than others because of the risks in the mortgage and loan servicing industry, and they want to be sure they can recoup their losses in the event of a claim. Most lenders add the policy premiums to monthly mortgage payments, which can also make them significantly higher.
What sets these policies apart from other homeowners insurance options is the claim process. If something goes wrong, the mortgage lender — not the homeowner — makes the claim on the policy. The insurer will reimburse the lender for the replacement costs or the mortgage balance, leaving the homeowner on the hook to replace their belongings, cover temporary living costs, and secure new housing.
It’s also important to note that failing to secure homeowners insurance and triggering a force-placed policy can have a detrimental effect on the mortgage loan. Some lenders include a clause that will automatically put the loan into default if the borrower fails to provide proof of adequate coverage.
Requiring borrowers to take out a private mortgage insurance policy is another approach to minimizing risks.
Typically, lenders require homebuyers who make a down payment of less than 20% of the home price to purchase private mortgage insurance. These policies cover a percentage of the loan’s balance if the buyer defaults, reducing the risk of a substantial loss.
For example, assume that the PMI policy covers 25% of the loan balance. If a borrower defaults on a loan worth $250,000, the bank can recoup $62,500 from the PMI and will lose $187,500. The bank will foreclose and sell the property to recoup as much money as possible, but PMI reduces the burden.
Not all buyers must purchase PMI, and it’s not always a permanent expense. Lenders use the loan-to-value (LTV) ratio, or how much of the home price you borrow. For risk control, lenders typically require a minimum LTV of 80% to waive the mortgage insurance requirement; in other words, buyers need at least 20% equity in the home.
As buyers make mortgage payments, they build equity and move toward the 80% threshold to drop the PMI. On average, it takes about 15 years for the typical homebuyer to reach that point since a substantial percentage of their payments in the first few years of home ownership go toward interest.
Many homebuyers ask why they have to pay for mortgage insurance if it covers the lender, not them. The answer is risk mitigation, and it’s one of several safety measures that banks use to ensure they don’t lose money. By purchasing the insurance, the borrower compensates the lender for taking a risk on them with the loan.
How much you pay for PMI depends on many factors. Lenders get to choose the PMI provider, so buyers cannot shop for the best deal, but most companies use similar calculations to determine the premiums.
These calculations consider:
Ultimately, annual PMI premiums typically range from 0.5% to 2.25% of the original loan value, but some policies cost more because of factors like a low credit score and minimal down payment.
Another element that plays into PMI cost is the type of premium you choose. This determines how you’ll pay for the insurance policy and can significantly affect the overall cost. There are five types of premiums.
You make a monthly payment in addition to your mortgage until you reach 22% equity in the home, at which point the lender automatically cancels the policy.
You pay the entire PMI premium in cash at closing or roll the amount of the insurance into the mortgage, which lowers monthly payments.
The lender technically pays for the insurance in the form of a slightly higher interest rate. However, the only way to stop these payments once the equity hits 22% is to refinance the loan.
You pay some of the total cost up front in cash and then cover the rest as part of your monthly mortgage payment or add it to the loan. This arrangement is ideal for buyers with a high debt-to-income ratio who might not otherwise qualify for a mortgage when the monthly payment includes PMI.
This is a program for people buying homes using FHA loans with a down payment of less than 10%. You’ll pay some of the premium up front and the rest monthly. You must carry the coverage for at least 11 years.
Whether or not your lender requires you to purchase insurance on your mortgage, it’s imperative to carry a homeowners insurance policy as a means of risk mitigation for you and the bank. Unlike PMI, you can choose your insurance carrier, and the best way to do that is to use Insurdinary’s simple online quote tool. Just enter details about your home and the coverage you need, and we’ll find multiple competitive quotes for you to shop and compare.
When you’re ready to buy, one of Insurdinary’s experienced insurance professionals will help you enroll and get the necessary coverage. We’re here to help, so contact us anytime you need more information.