Lenders Mortgage Insurance can help you get into the property market sooner. But as Momentum Wealth’s Finance Broker Maxwell Miorada explains, there are pros and cons to weigh up.
What is Lenders Mortgage Insurance?
Lenders Mortgage Insurance (LMI) is a type of insurance that protects the lender – not you – if you cannot keep up with your home loan repayments.
When you buy a property with less than a 20% deposit, the lender will normally ask you to pay LMI.
There are, however, exceptions to this. The Federal Government’s First Home Guarantee scheme allows eligible first home buyers to buy with 5% deposit and no LMI as the government guarantees the remaining 15%.
How much does LMI cost?
How much you can expect to pay in LMI depends on a variety of factors. A common thread is that LMI increases when you have a lower deposit because it’s directly linked to the risk perceived by the lender. Essentially, the less money you put down as a deposit, the more you need to borrow, which increases the loan-to-value ratio (LVR).
The higher the LVR, the greater the risk for the lender. If you as a borrower default on your payments and the lender has to sell the property to recoup the loss, a lower deposit means there’s a greater chance that the sale price won’t cover the full loan amount, especially if property values have decreased.
As a rule of thumb, for every 5% increment your LVR surpasses 80%, the LMI cost you incur will increase significantly.
The pros of buying with a low deposit and paying LMI
Although LMI is designed to protect lenders, it can provide you as a buyer with various upsides. These include:
- You get into the market sooner: No matter whether you’re buying an investment property or choosing a home to live in, the sooner you get into the market and start paying off the loan, the sooner you begin to reduce the debt, accumulate equity and start building wealth.
- You can beat property price hikes: LMI can let you buy at today’s prices and beat future price growth.
When property values are rising strongly, it can cost less to pay LMI and buy now, rather than wait until you’ve saved a 20% deposit. By this time, values may have risen by far more than your LMI premium.
- You can afford a better quality property: LMI allows you to buy at a higher price point.
An investor with $100,000 for example, can either put a 20% deposit on a $500,000 property and pay zero LMI, or use the $100,000 as a 13% deposit on a $750,000 purchase if they pay LMI.
In this way, LMI can provide the opportunity to buy a higher quality property or one in a superior location, which is likely to deliver higher rates of capital growth. Or it can help you buy a nicer home to live in.
It’s not just about buying a better property. In Perth’s current market, there is a limited supply of houses priced at the city’s median dwelling value ($588,454 as at June 2023 according to CoreLogic, 2023). Buyers who can step up to the next price bracket enjoy a considerably greater choice of properties, providing more flexibility when searching the market.
The downsides of buying with a low deposit and paying LMI
There are possible drawbacks of paying LMI, which include:
- You will likely pay a higher interest rate: Across the mortgage market, interest rates are generally lower for borrowers with a bigger deposit. This is shown below.
Rates for home buyers with 20% deposit (80% LVR) are currently around 5.84% (principal plus interest loan) – a figure that can rise to 6.24% if you only have a 10% deposit (90% LVR).
Investors can expect to pay about 6.09% when they have an LVR of 80%. Dial up the LVR to 90%, and the rate can rise to 6.44%.
- You will have more debt: Buying with a lower deposit means taking on more debt. That said, there is an argument to say that additional debt represents what would otherwise have been prolonged savings.
- Your loan repayments will be higher: A bigger debt plus a higher rate inevitably means higher loan repayments.
As a guide, the repayments on a $500,000 owner occupied property purchased with a 20% deposit (80% LVR) would be about $2,294 monthly. Buy the same property with a 10% deposit (90% LVR), and the monthly payments jump to $2,695.
Did you know?
Depending on the lender, LMI may be partly refundable. If you refinance within 12 months to 80% LVR, or pay out your home loan, you could be entitled to a 40% refund on the LMI premium.
If you refinance within 24 months to 80% LVR, or pay out your home loan, you could be entitled to a 20% refund on LMI fee.
While buying with a low deposit and paying LMI comes with pros and cons, you need to address practical considerations such as how you will pay the LMI premium. LMI may be a one-off expense and either needs to be paid upfront or in some cases, the lender may allow you to add it to the loan balance and spread the cost out over time.
If you buy a property with a high LVR and the market softens shortly thereafter, you could find yourself in a position of negative equity. That’s where you owe more on the property than it’s worth. Negative equity eliminates the prospect of refinancing to a cheaper loan, potentially leaving you with little choice but to ride out the storm, and wait for the market to recover.
The upshot is that LMI can be a highly beneficial tool when it comes to buying a property as it provides you with the opportunity to escape the rental market sooner and accelerate your journey towards building wealth through property. But as everyone’s circumstances are different, it’s important to speak to a mortgage broker to know if buying with a low deposit and paying LMI is the right strategy for you.