What is mortgage default insurance? Why do I have to pay for it?
When applying for a mortgage you are bombarded with all the different insurance types. This may be overwhelming as it is not always clear what they are, what they cover, the difference between those, which ones are must-haves vs. good to have.
Below are the types of insurance that you will encounter when applying for a mortgage:
Default Insurance
Mortgage Creditor Insurance
Term Life Insurance
Property Insurance
Title Insurance
In this post, we will discuss mortgage default insurance, its amount, and the reasons behind it.
What is Mortgage Default Insurance?
Mortgage default insurance is an insurance policy between the insurer and the lender that will compensate the lender for losses suffered on an insured loan. It’s important to note that, despite the borrower paying the insurance premium, the mortgage default insurance does not compensate the borrower. Also, the mortgage default insurance premiums are not refundable if your mortgage is paid early.
The default insurance is usually required on mortgages with a high loan-to-value ratio, meaning the borrower provides a low downpayment. For example, in Canada, mortgage default insurance is required by the Government of Canada when your down payment is less than 20%. Thus, if you provide a downpayment of 20% or above, you are not required to pay the mortgage default insurance.
The amount of insurance will also differ depending on the amount of downpayment below 20% that you provide. For example, if you provide a 5% downpayment, the usual default insurance will amount to 4% of the mortgage amount. With a 15% downpayment, the default insurance is ~2.8% of the mortgage.
Thus, the default insurance may come up to a sizeable addition to your mortgage amount. For example, if you are buying a property for $530,000 with a downpayment of $30,000, your mortgage will be $500,000. However, you should be prepared that after the default insurance is added to the mortgage, your total loan will increase to $520,000. This amount will then be used for calculating your monthly mortgage payments.
It may sound counterintuitive to add additional money to your mortgage to protect the lender from defaults on this insurance. In the end, you are not planning to default on your payments. Why do you have to pay extra? Think about this in terms of how general insurance works. It has to work with the calculated risk. For example, you pay $100 a month for property insurance. When your house burns down, it is your payment and the payments of other people that the insurance company will use to pay you. This is also the case with default insurance: while you plan to pay your mortgages, somebody else may default due to unforeseen events. Also, default insurance is crucial during housing and mortgage markets crises (similar to the 2009 crisis) when a wave of defaults sweeping through the country. Without default insurance, most financial institutions would face bankruptcy which would further deepen the crisis in the country.
How does mortgage default insurance work?
First, the insurance company charges the mortgage default insurance premium to the lender (a bank or another financial institution you get a mortgage from).
Then, the lender typically passes that premium on to the borrower. Normally the lender will add the premium to the amount of the mortgage and the borrower will pay it back to the lender over the life of the mortgage in monthly payments. The borrower could pay this insurance in cash to the lender upfront, but this usually does not happen as the borrower uses all available cash for downpayment.
Later, if the borrower goes into default (normally by failing to make his or her mortgage payment), the lender must undertake steps to collect the defaulted payments. If the lender fails to collect these payments it will power the sale of the property, one of two outcomes will occur:
If the lender sells the house for more than the outstanding loan, it must give that profit to the homeowner. The homeowner and the lender are then done with one another.
If the lender sells the house for less than the outstanding loan the lender suffers a loss. Since the mortgage is default insured, the lender makes a claim to the insurance company to recover that loss. The insurance company pays the lender and the lender assigns any debts payable to it by the borrower to the insurer. In other words, the money that the lender was owed by the borrower is now owed to the insurance company. The insurer may then take legal action against the borrower to recover the claim that it paid to the lender.
Benefits of the default insurance to the lender
Allows the lender to make loans with little downpayment from the borrower. In case of a default by the borrower, provides safety by recovering insured losses.
Benefits of the default insurance to the borrower
Allows the borrower to receive a high ratio mortgage with favorable terms and a favorable interest rate.
The premium for the insurance is paid once and is included in the total mortgage amount. Thus, you don't need extra upfront cash to pay for it and would just pay it in monthly or bi-weekly payments over the course of the mortgage. However, keep in mind the insurance also offers the flexibility to pay the premium in cash if you don't want to pay the interest on this amount.
Drawbacks of the default insurance to the borrower
As discussed before, the default insurance is adding up to 4%-4.5% to the amount of your mortgage. It may be a sizeable amount. For example, on a $500,000 mortgage the default insurance will add $20,000. Given this money will accumulate interest similar to the main mortgage portion, the total cost of the default insurance will be even higher.
What is a default management program?
Most default insurance companies will provide mortgage default management programs (also known as "workout options"). These programs are designed to assist borrowers who get into financial difficulty and have trouble making their scheduled mortgage payments.
Typically, these programs are provided through the lender in conjunction with the insurer and are designed to provide a solution. These options can include:
Special Payment Arrangements
A lender may make arrangements with the borrower to recover payment arrears over the shortest period, as long as it is within the borrower’s financial ability.
Reamortization
A lender may increase the amortization of a mortgage when the default is due to the payments no longer being affordable for the borrower. For example, a lender may extend the amortization up to 30 years.
Capitalization
This procedure allows the lender to add the amount of arrears to the loan amount. For example, a lender may increase the mortgage loan by the amount of the outstanding payment.
Other options
Lenders may have additional options that can be approved by the insurer before implementation.
Â
In summary, default insurance is necessary insurance as it protects the lender and the country's economy. You cannot escape this insurance unless you have a minimum 20% downpayment. It can be a sizeable addition to the total mortgage loan, however, you don't have to pay it upfront. Rather, it is added to the total amount of your mortgage and you pay it in perioding payments. You can reduce the premium by providing a higher downpayment. You can also reduce the interest on the money you borrow by paying the default insurance upfront in cash.