Borrowers who put less than 20 percent of a home’s value down for a mortgage almost always have to secure “private mortgage insurance” (PMI) to protect their lender if they default. In 2007, PMI became became tax deductible for borrowers, thus further lowering the cost of homeownership and encouraging more people with small down payments to begin buying homes.
As it stands, the PMI creates enormous perverse incentives: it encourages lenders to lend to people who put down as little as 3 percent of the value of the home. Since it is a rare product that brings no benefit to the “consumers” who buy it (it protects only lenders), PMI encourages borrowers to do anything they can to avoid having mortgage insurance and, understandably, shop on price alone. The system set many people up for a fall by encouraging lenders to take risks with borrowers who look very bad on paper. It was also subject to manipulation. By “piggybacking” loans on top of each other, borrowers could avoid paying for PMI –which costs about $50 a month per $100,000 financed–and leave the lenders with no protection at all despite financing almost 100 percent of a home’s value.
In fact, lenders almost always buy mortgage insurance themselves for borrowers who have more than 20 percent equity in the home and roll the premiums into the interest rate. So PMI is really just a way of making borrowers pay more without actually raising the interest or fees demanded by the lender. It actually reduces the stability of the market.
Thus, those who want a more stable housing finance system should revisit PMI. If lenders wish to require buyers to purchase PMI, then it’s perfectly sensible to tax the borrowers’ insurance premiums as income to the lender since the lender derives a direct benefit from it. Since there’s no particular virtue in buying PMI, furthermore, there’s no reason to continue the consumer-side tax deduction either. Under such a system, few if any lenders would require that buyers secure PMI–which is exactly what should happen.
Lenders, instead, would secure and pay for mortgage insurance themselves and it would be deductible to them as a business expense. Borrowers, of course, would not get a “free lunch” from this—mortgage rates, fees, and other costs would rise by the cost of insurance. (Because lenders have more buying power with insurers, however, borrowers who put little down would probably see a slight reduction in total housing payments.) Since lenders would make almost all decisions about mortgage insurance, furthermore, they would have a much greater incentive to make sure that PMI worked and look out for piggyback schemes and other efforts at deception.
Getting rid of PMI-as-we-know-it isn’t a panacea. But it could make things better.