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Ben Kingsley Blog post by Ben Kingsley

Understanding Lenders Mortgage Insurance (LMI)

Post the Second World War, Australia transformed itself into ‘The Lucky Country’. We opened our doors to large levels of immigration and we had plenty of land, food, water and great weather that made us attractive for many who were fleeing war torn areas of Europe and alike. It was also through this era that we got our second great tag line of ‘The Great Australian Dream’, which translates to the ability to own a home in this fine land.

Now back in this period, to buy a home you needed to save a deposit of 20% of the value of the property, which required the discipline of good money management and sacrifice to achieve the goal of home ownership. I recall my parents bought their first property in Bundoora for $13,000 in 1970 and they told me that it was true for them as well, that they needed to save up that 20% deposit and also establish a relationship with their local bank manager. Back then, bank managers had a lot of power and influence as they were the ones that controlled the flow of money from a bank.

How times have changed; with the advent of computers, then networked computer and now the internet, the evolution of banking has put more power and control in the hands of the consumer than the bank themselves. These days almost 50% of consumers now use a Mortgage Broker as their preferred professional to help them source a home loan instead of going directly to a bank.

The evolution of banking has also seen the introduction of Lenders Mortgage Insurance. It’s actually been around for several decades now and it was born out of the idea that rather than a household having to save up a deposit of 20%, which given the increase in property prices could mean that some budding home buyers looking to buy in the higher priced suburbs could be forced to save for an eternity, they would be able to still buy the home with less accumulated savings.

 

Here’s how it works:

The banks are a conservative lot; they still only want to
risk lending 80% against a valuation of property, meaning that if the property was to drop by as much as 20% the money that they lend would still be safely returned. (Banks don’t lose!).

Step in the Mortgage Insurance Company, they work with the banks to allow the bank to lend up to 95% of the value of the property, by insuring the bank against the borrowers risk. Meaning that if the borrower was to default and the property was to be sold as a lower amount than what the bank had lent the borrower, then a claim would be made against that insurance policy and the bank would be paid by the insurance company the difference (loss) from what the bank had originally lend.

 

Follow this example:

Buyer pays $500,000 for a property – with stamp duty costs and other purchase costs it will add an extra 5% bringing the total cost to buy the property to $520,000.

Without Lenders Mortgage Insurance the bank would only lend to 80% – in this case $400,000, so for the buyer to buy this property they would need to have $120,000 to complete the sale.

With Mortgage Insurance the bank is willing to lend 95% Loan to value Ratio (LVR) of the value of the property ($500,000 x 95% = $475,000). That’s an extra $75,000 the buyer can borrow from the bank if they pay the Lenders Mortgage Insurance (LMI) Premium. So in this example the if the property was going to cost $520,000 and the buyer could get a loan for $475,000 then the buyer would need to have $45,000 in savings to complete the sale, PLUS the Lenders Mortgage Insurance Premium instead of a $120,000 savings.

 

Loan to Value Ratio:

LMI is calculated by using the Loan to Value Ratio (LVR). As I mentioned earlier, if the LVR of a property is below the 80% mark, then no LMI premium is payable. To calculate the LVR you simply divide the loan amount by the property’s value.

EG: Loan amount $437,000 / Property Value $500,000 = 87.40% LVR

 

About the LMI Premium:

In the $500,000 purchase example above where we have a deposit of $25,000 (exclude the $20,000 in additional costs), if you used the Genworth LMI Premium Estimator (calculator) the LMI premium figure is $17,480 (assuming not a first home buyer) or $15,722 (assuming they are a first home buyer).

Importantly, each lender negotiates their own premium levels with their insurance provider, one can only assumed based on the volumes they give the insurance company, hence insurance premiums for the same LMI policy can vary significantly from lender to lender. In some cases, this can make a loan with one lender with a slightly higher interest rate, still cheaper than a lender with a lower interest rate but a high LMI premium, so that’s why you should always use a Mortgage Broker to help you choose the best lender and loan product for you.

But wait there’s more……

Some lenders also allow you to ‘capitalise’ the premium into the loan, which means once again it’s less out of pocket amount for the buyer/borrower to be able to purchase the property. Of course it will mean that you will be paying interest on the greater amount you borrow, so you will need to weigh this up in your thinking. For some people getting into the property now might be more important than having to wait until they can save more money, others might choose to wait.

Final word….

A LMI policy only protects the bank against the borrower defaulting on the loan. It does not protect the borrower, even though the borrower pays the premium. It’s also worth noting that the insurance company might seek to pursue the borrower for any money that it pays out to the banks, so the message should be very clear – don’t take on more debt than you can afford and when working out what you can afford, make sure you take into consideration any changes to income and expenses into the future, because a loan of this size is usually going to take many years to pay off.

 

Remember knowledge is empowering if you act on it.

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