Contribution from loanscanada.ca
There are plenty of areas in life that require insurance to be paid. Property insurance, life insurance, car insurance, the list can go on. One unique type of insurance that you may be required to pay is mortgage default insurance, which is applied to mortgages that come with low down payments.
While the thought of insurance premiums on your mortgage doesn't sound great, this type of policy makes it possible for many Canadians to become homeowners when they otherwise wouldn't be able to qualify for a loan to finance a home purchase.
Let's look into mortgage default insurance in greater detail to help you get more familiar with what it is, why you may be required to pay for it, and how you might minimize it or avoid it altogether.
Mortgage default insurance is required to be paid by homebuyers who take out a mortgage with a down payment that's less than 20% of the purchase price of the home. It's a unique type of insurance because even though you are the one who is responsible for paying it, these policies are designed to protect the lender, not you.
Lenders want to lower their risks as much as possible when they extend loans to borrowers. When a borrower puts forth a large down payment toward the purchase of a home, they have more equity in the property and owe less on their home loan. This lessens the risk for lenders, as the borrower doesn't have as much outstanding debt.
But with a much higher loan-to-value ratio (LTV) - which is the loan amount relative to the value of the property - the lender is at greater risk if the borrower defaults on the home loan. If this happens, a mortgage default insurance policy will compensate the lender for any losses incurred as a result of a default on the mortgage.
This policy will allow the lender to recover the balance of the funds borrowed, plus be compensated for any unpaid interest or legal fees. Any shortfalls in funds recovered by the lender will be compensated by the mortgage default insurer.
As mentioned, mortgage default insurance premiums must be paid if you put forth a down payment that is less than 20% of the purchase price of your home. The amount that you must pay will depend on the size of the down payment you make when you take out your mortgage.
If you continue to make your mortgage payments on time every billing cycle, then the mortgage default insurance will not kick in. But if you continue to miss your payments and default on your mortgage, your lender can step in and use the mortgage insurance policy to recoup the money you owe them.
If the lender chooses to repossess your home and force a sale, the proceeds of the sale could then be used to recover all the funds you still owe the lender. But if less money is made from the sale of the home compared to the outstanding mortgage balance, the difference would be covered by the insurance provider.
Your mortgage default insurance premiums are calculated by multiplying the insurance rate by the loan amount you take out to finance your home purchase. This rate is established by your mortgage insurance provider and will depend on how much of a down payment you come up with. Generally speaking, the lower the down payment, the higher the rate, making your premiums more expensive.
The following rates apply:
To illustrate, let's say you're making a 5% down payment on a $700,000 home purchase. That means you'd have a mortgage of $665,000. Based on the chart above, that means you'd be charged an insurance rate of 4.00%. When calculated with the outstanding loan amount of $665,000, your insurance premium would be $26,600, which would be added to your loan amount, bringing your mortgage amount to $691,600.
You would then have to repay $691,600 over your entire amortization period, plus interest.
Mortgage insurance premium payments are typically rolled into the cost of the mortgage and paid back over the life of the loan. That means you won't have to come up with a lump sum of money to pay for the policy in full, as you would with other typical closing costs. Every mortgage payment you make will include a portion that goes toward paying the mortgage default insurance premium.
If you want to avoid paying mortgage default insurance altogether, the only way to do that is to come up with at least 20% of the purchase price in the form of a down payment. In order to afford to do this, you will either need to work diligently to save this money or consider purchasing a home on the lower end of the price spectrum.
If you are in a situation where you can't avoid paying this insurance premium, the only way to minimize your payments is to boost your down payment amount relative to the cost of the home. If you are a first-time homebuyer, you may be able to borrow against your RRSPs through the Home Buyers' Plan (HBP). You may also reduce your premiums by moving to another home thanks to a “portability option,” which can reduce or eliminate your premium on a new insured home loan to purchase another property.
Having another insurance premium to pay can certainly be a nuisance. But it's a necessity if you are unable to come up with a 20% down payment on a home purchase. That said, think of this premium as an opportunity to buy the home you dream of that may otherwise not have been possible. Having said all that, it's still possible to minimize your premiums so that you're not stuck paying more than you have to throughout your loan term. Be sure to speak with a seasoned mortgage specialist to help you make the right choice based on your needs.
Confused about mortgage default insurance vs. mortgage life insurance? Read up on our blog for more info!