At face value, lenders mortgage insurance (LMI) may seem expensive, but when you consider some of the benefits, you may be asking yourself whether you can really afford to be without it…
What is LMI and how does it work?
LMI is an insurance policy that some lenders will require the borrower to take out (typically if your property loan deposit is less than 20 per cent of the total value of your property – or in other words if your loan to value ratio (LVR) is more than 80 per cent).
The purpose of LMI is to protect the lender from financial loss if the borrower can’t afford to meet their home loan repayments.
If the borrower defaults on their loan and the sale of the property doesn’t equal the unpaid value of the mortgage, lenders can claim on the LMI policy to make up the difference.
Mortgage insurance helps reduce the risk posed to a lender when a borrower only has a small deposit. If the borrower defaults on the loan, the lender could sell the property but with a reasonable risk of not recovering the full loan amount because of overdue interest, legal and real estate agent fees.
There is also the possibility of the property selling for less than it was bought. If mortgage insurance was not available, it may not be possible to borrow money for property unless a 20 per cent deposit was paid, an amount generally understood to be greater than the costs associated with a mortgagee sale when a borrower is in default.
What is the cost of LMI?
Mortgage insurance can be upwards of $15,000 on a $500,000 loan (with a $25,000 deposit), a possible shock considering it is an insurance cost the borrower pays, yet protects the lender. While this can seem high, the benefits such as reduced opportunity cost and higher return on investment can make the cost seem like good value.
Reduced opportunity Cost
Consider how long it would take to save a 20 per cent deposit to avoid mortgage insurance. Now consider how much the property is likely to have increased in value in the meantime. A $15,000 mortgage insurance can seem cheap compared with the potential opportunity loss. It is rare to find first property buyers who can save a 20 per cent ($100,000) deposit in less than three to five years. So when you consider how much a property’s value is likely to increase in that time – up to nine per cent – the cost of mortgage insurance looks very worthwhile indeed!
Increased return on Investment
Return on investment is simply the ratio of money you put into an investment verses the total return it provides. In property, when you borrow most of the funds, your investment consists mainly of the deposit and costs you contribute. The return is mostly the capital growth, as the rental income generally pays the interest of the loan. Therefore if you contribute 20 per cent ($100,000) deposit and costs for a $500,000 property and the property grows by 10 per cent ($50,000) pa, the simple gross return on investment (ignoring selling costs) is 50 per cent. Compare this with contributing 10 per cent ($50,000) in deposit and costs, including the mortgage insurance, for the same property that achieves 10 per cent ($50,000) growth. The simple gross return on investment (again, ignoring selling costs) is 100 per cent!
Even if the same property achieved a lower rate of growth of six per cent, the relative increase in return on investment is still much higher if you use a smaller deposit and pay mortgage insurance. This same principle can be extended to buying more property for the same deposit and keeping some savings as a buffer to help reduce risk.
Richard Sheppard is the CEO and Chief Property Investment Advisor at inSynergy Property Wealth Advisory. inSynergy provides professional property investment advice, property market research, specialised mortgage broking services and is an accredited investment property buyers’ agent.