What is mortgage insurance?

Lender mortgage insurance, often referred to as LMI, is an insurance taken out by the lender to protect them against the borrower defaulting on their loan.

It is a one-off payment, paid by the borrower, when the loan is first taken out if the loan is above 80 per cent of the value of the house: e.g. if the house was worth $400,000 then an 80 per cent lend would be a $320,000 loan.

Anything above 80 per cent is considered a higher risk for the bank to lend against as there is less hurt money (equity) in the property if the borrower were to default.

As the loan to value ratio (LVR) gets higher (80 per cent to 95 per cent) the cost of the mortgage insurance premium increases as the risk increases. As a rule of thumb, the cost doubles from 80 per cent to 85 per cent, then doubles again to 90 per cent and again to 95 per cent.

95 per cent is the maximum you can borrow against a house and the mortgage insurance cost can be over $10,000. It’s uncommon for first home buyers to avoid mortgage insurance all together, but it’s not a bad thing.

The following scenario shows that a borrower may be better off purchasing a house now with a smaller deposit and pay LMI, instead of saving a higher deposit to reduce the LMI cost.

John Smith wants to purchase his first home for $400,000. He has saved a $10,000 deposit over the last four years and is happy to use his $40,000 in full to purchase a house. Assuming house prices are increasing at five per cent per year, if John purchased today and paid approx $15,000 in LMI, his house would be worth $20,000 more in a year’s time. This means John has made back his LMI cost in the first year.

Let’s now look at John’s second option, to wait another two years to save an extra $20,000 giving him $60,000 deposit for his house. Again, assuming house prices rose by five per cent per year, this would mean John has $60,000 to purchase the same house that is now worth $441,000. John's LMI cost now is approx $12,000. Only a small saving in LMI for all the effort of saving a further $20,000 over two years and the bigger issue is John missed out on the increase in the house price of $41,000.

If you understand that it allows you to get into the property market with less money, mortgage insurance is not something to be scared of.

Read more:

3 big risks to your positively geared strategy 

Exclusive series: The 6 week property transformation - episode 5

7 steps to building a massive property portfolio: Part 7

Is a renovate-and-flip project right for you? 

6 ways to maximise your investment's sale price