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The Mortgage Professor: With Loan Insurance, Bad Rules Lead to More Rules

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By Jack Guttentag

(MCT)—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 the Federal Housing Administration established termination rules applicable to the mortgages it 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—or property value less loan balance—is less than 20 percent, the termination rules all dance around that number. If equity of 20 percent 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 home values are below their previous highs.

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.

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