An interesting part of the debate on the difficulties facing first home buyers is the application of Lenders Mortgage Insurance (LMI) and its pros and cons. But before we delve into that discussion, it’s important to understand exactly what it is.
LMI is insurance a lender takes out against making a loss on a loan they provide. In simple terms, if a borrower defaults on their loan and the lender is forced to sell the property that secures the loan, in some circumstances, the sale proceeds will not cover the amount owed to the bank. When that occurs, the lenders mortgage insurer will cover the lenders shortfall.
Most borrowers understand that, but what many do not know is that the mortgage insurer can, and will, pursue them for the amount of the shortfall. LMI is therefore protection for the lender only – it does not offer any protection for the borrower at all. Furthermore, a common misconception is that it covers the loan payments if the borrower is unable to because of illness, losing their job, etc. It does not cover those risks, they are covered by separate policies such as income protection insurance that the borrower must arrange themselves.
Lenders usually require LMI when the loan amount is greater than 80% of the security value. This loan amount/security value ratio is called the “Loan to Valuation Ratio (LVR)” and it’s a critical figure when assessing if LMI is applicable, and if it is, what the cost will be.
Like all insurance policies, there is a premium or cost for the policy, and in most cases, this is passed on to the borrower. The cost of the premium depends upon both the amount of the loan and the LVR. The higher these are, the higher the premium will be. This is a reflection of the risk to the lender. The higher the LVR, the higher the possibility the lender will make a loss if they are forced to sell the property to recover their money. The higher the loan amount, the greater the potential loss.
The premium is payable by the borrower at settlement of the loan. The borrower can pay that from their own funds, or it can be added to the loan amount. That is termed as “capitalising the cost” and can be done provided the policy for the lenders maximum LVR is not exceeded. Of course, if you choose this option, you are repaying the amount over time, and paying interest on the monies owed (which includes the LMI premium).
It sounds very one-sided in favour of the lender and it is, but it does have its advantages.
Let’s consider two scenarios:
1. Purchasers can buy into the market sooner if they are having difficulty saving for a deposit
This is a significant positive and commonly applies to first home buyers. If the first home buyer is buying into a rising market, they will not need to save as much. Additionally, the capital gain generated in the time it would have taken to save the 20% deposit (plus costs) may, in fact, be more than the premium they pay. This has been evident in the property markets of Melbourne and Sydney over the past few years.
Let’s assume you want to purchase a unit in a market growing at 10% per annum, and the unit price is $500,000. To avoid LMI, you will need to meet the 20% deposit and the costs including Stamp Duty. Using round figures, you will need $100,000 to avoid paying LMI.If it takes you two years to build your savings to $100,000, in that time, the property will increase in price to $605,000. So, you would then need $121,000 to avoid paying LMI, i.e., you are still not in a position to buy the property, and have wasted two years!
Alternatively, if, at the time, you put together enough funds to pay 10% plus the costs and taken a loan with Lenders Mortgage Insurance at a 90% LVR, the LMI cost would have been approximately $8,500. Given the gain in property value over the two years was $105,000, obtaining the loan initially and paying LMI would have left you well ahead.
Sounds great, but remember, not all property values rise in this way, and the booming markets of Sydney and Melbourne are not typical of the overall property market. So do your homework and use a professional to help you.
2. It enables you to preserve your cash/savings for other use
If you have significant cash reserves, but have them earmarked for other purposes, you may be able to borrow more than 80% of the property value and not have to use all of your hard-earned savings. This can be advantageous from a tax point of view if purchasing an investment property, as the borrowings will carry some tax benefits, and the savings can be used for non-deductible spending. As always, you should check this strategy with your accountant to ensure it suits your circumstances.
So, under certain circumstances, LMI is an excellent tool to help buyers achieve their property goals. But there are many factors to consider and each individual has different circumstances. Like all lending decisions, there are implications for the borrower no matter which course they take, so use a finance expert to guide you, or speak with the team at Switzer Home Loans.
Adrian Sheahan is the manager of lending operations at Switzer Home Loans.Contact him today