Bad Rules Lead to More Rules: The Example of Mortgage Insurance Termination

December 15, 2013

In 1999, Congress decreed that the monthly mortgage insurance premiums that borrowers paid could be terminated by the borrower under certain conditions, and if the borrower failed to act, the lender was obliged to terminate a little later. This rule applied to mortgages insured by private mortgage insurers. Shortly thereafter, Fannie Mae and Freddie Mac issued their own termination rules covering mortgages that they had purchased, and FHA established termination rules applicable to the mortgages that agency insures.  

The rules of the three agencies are different, and all of them are complicated. The major issues are the conditions under which borrowers are allowed to terminate, and the conditions under which lenders are required to terminate.  

Since mortgage insurance is required when a borrower’s equity in the property (property value less loan balance) is less than 20%, the termination rules all dance around that number. If equity of 20% is safe enough to avoid insurance when the loan is taken out, it ought to be safe enough to drop insurance sometime in the future. But that leaves the question of whether the borrower’s current equity should be calculated using the property value when the loan was taken out, or the current market value? The original value would seldom be accurate, but the current value has to be documented. Where the rule specifies current value, the cost of documentation is borne by the borrower.  

There may also be other developments since the loan was written that affect its risk to the lender. For example, even if the borrower’s equity meets the required threshold now, should termination be allowed if the borrower has been chronically late on his payments, or has moved out of the house and is renting it? Under the rules that have emerged, the answer to both questions is “no”.  

All the termination rules stipulate that if the value of the property has declined since the mortgage was originated, it cannot be terminated. This rule was largely disregarded before the financial crisis because very few houses declined in value, but it is a major consideration today because in many cases house values are below their previous highs.  

Borrowers looking for an itemization of all the termination rules to see where they stand can find it in Cancelling Private Mortgage Insurance (2) 

While the insurance termination rules are favorable to borrowers and were supported by major consumer groups, they were needed only because of a highly dysfunctional feature of the housing finance system: mortgage insurance protects the lender but is paid for by the borrower. If not for that nonsensical arrangement, there would be no need for complicated mortgage termination rules.  

The core problem is that the lender receiving free insurance protection has zero incentive to terminate it. On the contrary, lenders have every reason to keep the insurance in place because it generates more revenue for the insurer, who is selected by and therefore beholden to the lender. While a direct payment by an insurer to a referring lender is illegal, there are legal methods by which insurers can demonstrate their appreciation to the lenders who select them, 

There is a very simple way to protect borrowers from paying for mortgage insurance that is no longer needed to protect the lender:  require that lenders pay for the insurance that protects them. This radical idea would have the mortgage insurance market work like every other insurance market, where the rule is that the party who is insured pays for the insurance.  

If this almost universal rule was extended to the mortgage market, the cost of the insurance would then be embedded in the price of the mortgage alongside all the other costs of making a home loan. Lenders would decide when to terminate insurance on individual loans based on whether they believed the risk remaining in the loan justified their continued payment of the premium. The borrower would be out of it. 

Requiring lenders to pay for the mortgage insurance that protects them would generate another major benefit for borrowers: the insurance premiums that would be embedded in the mortgage price would drop like a rock. In the existing system, lenders have zero interest in lower premiums for borrowers, because high premiums increase the value of lender referrals to insurers, and therefore encourage larger paybacks to lenders. But if lenders had to pay for the insurance themselves, they would use their market muscle to minimize their costs.  

Bad rules create new problems that require additional rules to fix, but the fix is never as good as getting the original rule right.


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