Last week, I wrote an article on how home mortgage borrowers who have been required to purchase mortgage insurance could earn a high rate of return by paying it off. That article ignored what would have been the first question posed by a smart visitor from Mars: Why does the borrower pay for insurance that protects the lender?
I will return to that question below, but as a backdrop to it, readers should understand why that question is important.
It is important because a system in which lenders paid for mortgage insurance, with the cost included in the price of the mortgage, would be substantially less costly to borrowers than the current system, in which the borrower pays directly.
Why a Borrower-Pay System is Excessively Costly
So, what’s wrong with a borrower-pay system?
For one thing, lenders receiving insurance protection paid for by borrowers have zero incentive to terminate it.
On the contrary, their interest is in keeping it in force because it reduces their risk and costs them nothing. Keeping it in force also generates more revenue for the insurer, with whom they probably have a long-term relationship.
This feature of borrower-paid insurance was the motivation for the legislation enacted in 1999 that allowed borrowers with private mortgage insurance to terminate it when certain milestones were reached. However, the rules regarding termination are complicated and the costs of the process to both borrowers and lenders are significant.
The second reason borrower-pay is excessively costly is that premiums are not subject to competitive pressures. Borrowers purchase insurance from the insurer designated by the lender, which means they have no market power. Lenders have market power because they select the insurer and refer multiple loans, but they have no incentive to use their power to reduce premiums because they do not pay the premiums.
Shifting to Lender-Pay Would Reduce Costs
In a lender-pay system, the cost of mortgage insurance would be included in the price of the mortgage paid by the borrower. The incremental cost to the borrower, however, would be far smaller than the private mortgage insurance premiums they pay today. Lenders would keep insurance in place for shorter periods, and premiums would be lower.
In a lender-pay system, insurance would be in force for shorter periods because lenders would deploy automated systems that would flag when the risk had declined to the point where it no longer justified the premium payment. These systems would be much more effective than the clumsy rules legislated in 1999 under which borrowers were given the right to terminate their policies.
Premiums would be lower in a lender-pay system because lenders would have the incentive to minimize them, and the market muscle — associated with the capacity to place many policies — to bargain them down. The borrower would not be involved at all. What a blessing!
I should note that, with minor modifications, the arguments advanced above apply as well to lender’s title insurance, which also protects the lender and is paid for by the borrower.
Readers who have difficulty with these conjectures might ask themselves the following question: “What would happen to the total price of an automobile if it were sold without tires or batteries, which had to be purchased separately from dealers specified by the automobile agency?”
Why Do We Have a Borrower-Pay System?
A system where borrowers pay for insurance that protects lenders is dysfunctional, and it is also unusual. The general rule is that the party who benefits from insurance also pays for it. How did this dysfunctional practice happen?
The borrower-pay feature of mortgage insurance was adopted by the newly emerging private mortgage insurance industry in the late 1950s, following the model of the Federal Housing Administration, which was chartered in 1934. The FHA adopted borrower-pay because it was subject to legal interest rate ceilings, which were pervasive at that time. It would have been very difficult to sell insurance protection to lenders if the lenders had to pay the premiums while their ability to pass on the cost in the interest rate was limited by a rate ceiling.
In financial regulation, a good rule is one that makes the market work better, and a bad rule is one that makes the market dysfunctional. Interest rate ceilings are bad rules. The FHA remained subject to rate ceilings until 1983, when they were finally removed following several episodes of market disruption when market rates hit the ceiling.
The removal of mortgage interest rate ceilings eliminated such episodes, but the other dysfunctional effect of rate ceilings — the dysfunctional practice of having borrowers pay for insurance that protects the lender — lingered on after the ceilings were removed. The 1999 rule that granted borrowers the right to terminate insurance once a complex set of conditions has been satisfied, was an attempt to soften the worst features of borrower-pay insurance.
A much simpler and more effective rule would have required lenders to pay for mortgage insurance.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
