Lenders/Private Mortgage Insurance: What Is It and Why You Should Avoid It!

I wanted to start this post by stating that I am all for real estate ownership and investment. I’ve dedicated over half my working life and post-retirement to promoting the value of real estate. However, I must stress that I always sell the idea of real estate with one large caveat. Make sure you can afford owning or investing in real estate. This caveat brings me to Lender’s Mortgage Insurance (LMI), the topic of this post, and why I think you should avoid it at all costs!

What is Lender’s Mortgage Insurance/Private Mortgage Insurance?

As I mentioned in an earlier post, the majority of lenders, if not all, expect an 80% loan to value ratio (LVR). For example, if you were to purchase a property worth $100,000, the bank would expect you to contribute at least $20,000 of your own equity towards the cost of that property, for the rest to be secured by a mortgage. As median home prices increase beyond $100,000, so does that 20% deposit. In theory, the LVR alone would eliminate a large portion of the population from home ownership or investment. LMI is there to help would-be homeowners in bridging the difference needed for the deposit, and therefore help them realise their home ownership dream.

In my years of real estate sales and investment, all I can say is that LMI is akin to a nightmare masquerading as a dream.

LMI - Working Example

Let me illustrate with an example. Say you want to purchase a home worth $500,000. This is roughly the median home price in Perth, but certainly a discounted median price for other markets. The 20% deposit amount would equate to $100,000, which is the average yearly salary for a Perth resident (per Salary Explorer). Saving up one year’s salary can be an immense ask for most! So for the purposes of this example, let’s say you can only afford to provide a $50,000 deposit.

Using the above example, and relying on the calculator provided by Lendi.com, you would have an LVR of 90% and would be required to pay LMI in the realm of $8,378 to $11,899. Typically, you can capitalise this to the loan amount, but that effectively increases your economic LVR (i.e. the fully burdened mortgage cost). Further, just for argument’s sake, say you reduce your deposit to $40,000. The LMI you then owe balloons out to between $12,346 and $17,019. Note that this may not include the stamp duty that you would pay on top of the LMI, which ranges from approximately 9-11% in Australia.

In other countries such as the United States, LMI (referred to as PMI) may be applied at lower rates (on average). However, after the 2020 fiscal year, you are unlikely to be able to claim a tax deduction for this amount.

So Why Rely on LMI?

For first home buyers trying to enter the market, or for potential buyers that are currently cash-strapped, LMI provides a seductive solution. You can recognise your home purchase objective without overreaching your financial position. So why wouldn’t you do it, right?

Well for starters, LMI is not intended to cover the buyer. If you are unable to cover the 20% deposit required to secure a home loan, the lender will seek coverage elsewhere for the shortfall. The LMI issuer would serve as the intermediary, and in the event of any default on the loan or breach of loan terms, that same issuer would seek to recover the shortfall amount from you, the buyer.

This makes no sense to me. You take out life insurance for yourself. You take out home and content insurance for yourself. Health insurance is intended to cover you and your dependents. So why would you pay for insurance that will protect an independent party? By paying for LMI, you are not only deferring potential risk, but are potentially compounding it for a time where your financial position is uncertain. This seems contrary to the purpose of insurance.

When I was selling real estate, I had potential buyers try to convince me that this was a good idea – unsuccessfully, I might add! But while I vehemently oppose LMI, I can understand the allure. Home ownership is a monumental achievement for most people, and those same people are willing to assume a greater financial burden so that they can realise that achievement. My advice to these would-be buyers was to avoid this temptation at all costs, for a few reasons.

For first home buyers, that home purchase most likely won’t be your forever home. Therefore, you will be in a much stronger long-term position if you take a more conservative position for your first home and opt for higher leverage on future purchases.

For buyers that are cash-strapped or have low equity positions, I used to advise them against home purchases at that time. It may seem weird to hear a sales representative advising his clients to not purchase a product. However, I did it with the intention of preserving their future financial position, even if that wasn’t in the buyer’s mindset at the time.

I remember all too well how difficult it is to save for a deposit, and how important every saved dollar is to you when building a home. Scope variations and unforeseen conditions occur all the time during home building and renovations, so it is paramount to have additional cash flow to address these issues as they arise.

Won’t the capital gains on the property offset the LMI?

I read a post recently, where one reader mentioned that they were happy to pay LMI as the capital appreciation on their property far exceeded the LMI cost. While I’m glad it worked out for that particular person, I find this to be an unconvincing reason to agree to LMI.

In that example, you are assuming that the property market is in a steady upward trajectory. In reality, the property market, like other asset classes, goes in both directions and can remain low for sustained periods. Take Perth for example. The Perth property market has been in one of the longest depressed market states in its history, spanning over 5 years of negative growth.

Therefore, adding LMI to your overall loan balance (if you choose to capitalise) places you under further financial stress, particularly if the house median prices fall dramatically and leaves you under water (i.e. your loan value exceeds the market value of your property). That to me is too great a risk to take on personally, and I always sought to convince other buyers to view LMI in a similar light.

What should you do instead?

I believe buyer psychology is one of the reasons most people choose LMI. Once buyers get comfortable with the fact they will be financially responsible for the entire mortgage/interest sum for multiple decades, the additional LMI expense doesn’t seem too great.

I respectfully urge those considering LMI to steer clear from this thought process. Firstly, just because you can borrow more, doesn’t mean that you should – the goal should be to pay off debt as soon as practicable.

Secondly, if you were to refinance your mortgage, you may be subject to additional LMI charges, given that refinance is seen as a new loan (see here for more detail).

Instead of putting yourself under further financial stress, consider if the following options work for you:

1. Consider asking family and friends to help with the short-fall/provide a guarantee

Most new buyers I’ve encountered tend to shy away from requesting help from their loved ones, perhaps to showcase their maturity and independence. What I believe is more mature is to not over-leverage your first home, and instead ask for help on what is a significant financial undertaking.

There is no harm in asking a parent or loved one to cover the shortfall. Firstly, it is much easier to negotiate flexible repayment terms with a loved one than it is with an established lender.

Further, a benefit of having your parents guarantee your mortgage is that you may be potentially exempt from LMI. However, your parents should be aware of and understand the legal relationship they are creating and their obligations under the guarantee agreement and home loan agreement.

2. Obtain a personal loan

While it is another form of debt, a personal loan can be an alternative to covering the shortfall. Interest rates may be higher than what you get under a mortgage, however you can aim to repay this amount quicker with short-term cash flow that you generate. A short-term personal loan may also prove to be the cheaper option compared to LMI, however that will depend on the interest and repayment terms, the LMI rates offered by your lender, as well as the stamp duty rate that is applied on the LMI.

3. Consider a Reverse Mortgage

For those unfamiliar with reverse mortgages as a concept, they are effectively loans secured against the equity you hold in your home. They are commonplace among homeowners who have considerable positive equity in their homes. One of the benefits is that interest is deferred until the end of the loan term or a maturity event occurs, such as the home is sold or the owner passes away.

Reverse mortgages are a valid alternative to LMI. However, there are some big question marks over the safety on reverse mortgages, which I will cover in a subsequent blog post.

4. Save up for entire deposit

I predict this would be the least welcome suggestion, hence it rounds out the end of the list. As a homeowner myself, I understand the value and importance of owning a property. While it may be difficult and time consuming, it is certainly worth it to defer your home purchase decision until you can afford an 80% LVR. For starters, you have a healthy initial equity balance in the property that you can build over time. Moreover, you don’t unduly burden yourself with additional charges/debt, and can instead reallocate those saved amounts to better use.

I know it may be uncomfortable or stressful staying with your parents or relatives for those few extra months. However, if it means you can save up your entire deposit during that time, wouldn’t the temporary discomfort be worth it? That’s the advice I gave my own son, who was able to stay with us well into his 20s so he could save up for his investment properties. While he would have liked to move out earlier than he did, in hindsight, he is very content with his current position.

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I wish everyone nothing but success in realising their home ownership dream. However, all I ask is that you respect your budget and to not financially burden yourself in the effort of realising that dream. Remember that costs such as LMI are avoidable, particularly if you are able to save or obtain the funds elsewhere, so that it won’t negatively impact you in the future.

If you have any questions or thoughts on LMI, please feel free to leave a comment below.

The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.