When a lender lends money to a borrower, she takes on credit or default risk. Now, the lender generally asks for a down payment (varies 10% to 25% depending on the loan amount and some other factors) as margin to reduce the risk.
Note: RBI has mandated the LTV for a housing loan in the following link.
There is another way to reduce the risk – buying insurance on the debt payment. Mortgage insurance is used to reduce the credit risk associated with a mortgage in case of a default. The default may be caused by unforeseen financial distress of the borrower or sudden death of the borrower.
TYPE OF MORTGAGE INSURANCE
There are two types of Mortgage Insurance –
1. Private Mortgage Insurance (PMI) which protects the borrower in case the borrower is unable to pay the mortgage and
2. Mortgage Insurance Premium (MIP) which is a life insurance policy designed to protect the lender in case the borrower dies before the mortgage repayment.
ADVANTAGES OF MORTGAGE INSURANCE
1. For the borrower
As Mortgage Insurance reduces the default risk for the lender, the lender may agree to a lower downpayment. This means the borrower will be able to get a higher amount of loan for lower down-payment. Reduced default risk for the lender means that the lender may agree to a lower credit premium i.e. a lower interest rate for the loan.
Private Mortgage Insurance (PMI) safeguards the borrower from the lender in case of financial distress caused by say job loss.
2. For the lender
Mortgage Insurance policies reduce the default risk for the lender. It helps the lender recover borrowed amount without going through legal complications.
DISADVANTAGES OF MORTGAGE INSURANCE
The premium for a Mortgage Insurance may be paid as a lump-sum at the time of availing the loan or some lenders may allow it to be a part of the mortgage payment itself. In the case of the lump sum payment, there is a cashflow issue because it reduces the amount with the borrower to purchase the house.
In the case of the ongoing payment the mortgage payment increases.
80C tax benefit may not be available for the amount paid as premium for the Mortgage Insurance.
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