Buying a first home, or getting back into the market after a split? With interest rates at historic lows, there’s never been a better time to buy.
However, there’s still the matter of the deposit. If you want to avoid lenders mortgage insurance (LMI) you generally need to find 20% of the purchase price up front. Saving up that much, especially if you’re also paying rent, can be a daunting task.
But what if you embraced LMI instead? Understood correctly, it can represent an opportunity to get into the market sooner rather than something to avoid.
We spoke to John Rolfe, head of Elders Home Loans, for his insights into LMI and what other options are out there.
When you’re applying for a home loan, you can get bogged down in the terminology. For the purposes of this article, we’ll take a look at two terms. The first is Loan to Value Ratio, or LVR. The second is Lenders Mortgage Insurance, or LMI. They’re linked together, so you need to understand LVR in order to grasp when LMI is payable.
Loan to Value Ratio
LVR is the value of your home loan divided by the value of your property. When you are first buying a home, the value is the same as the purchase price. That means that the LVR is the ratio between your deposit and your loan.
For example, if you are buying a $500,000 property with a deposit of $100,000, your deposit is 20% of the purchase price. Your LVR is therefore 80%. If you buy the same property with a deposit of $50,000, your deposit is 10% and your LVR is 90%.
(We’re disregarding fees and charges for the purpose of this example, but usually stamp duty and other fees would be counted into your LVR.)
Over time, your property’s value will go up and the LVR will change.
In five years time, that $500,000 home might be worth $600,000. You bought it with a deposit of $100,000 and have paid another $100,000 off the loan. Now your loan is $300,000, or 50% of the total value. Your LVR is therefore 50%.
Lenders prefer to lend to people with a lower LVR, which means a larger deposit. The lower your LVR, the lower the risk to the lender because they know that they can sell the property and cover the outstanding loan.
If your LVR is over 80%, most lenders will require you to take out LMI. This is insurance that protects your lender, not you, if you can’t make your repayments.
The cost of LMI varies depending on your LVR and on the lender. It will be higher if your LVR is 95% (i.e., you only have a 5% deposit) than if your LVR is 85% and you have a 15% deposit. It will be added to the total cost of the loan.
Going back to our earlier example, if you had a deposit of $50,000 and therefore an LVR of 90% on that $500,000 home, you would need to take out LMI. As a rough guide, this might come to around $13,000. This then gets added to the loan so that you are borrowing $413,000 instead of $400,000 and your repayments are slightly higher.
What is the purpose of LMI?
Lenders mortgage insurance is mortgage insurance for the lender. If you are unable to meet your loan repayments, LMI pays the lender to cover their losses – not you. If you want to be covered if you lose your job and are unable to pay your mortgage, you will need to explore income protection insurance instead.
“The important thing for people to understand is that LMI is for the lender,” says John. “If you default and the bank ends up selling your house for less than the loan amount, the insurer will pay the shortfall to the bank. The insurer will then chase you directly for that amount, so you still have to pay it.”
Is LMI right for you?
If you don’t have a 20% deposit to spare, you have a few options. You can take out LMI, explore alternative lending structures or go with a family guarantee. Alternatively, of course, you can wait to get into the market while you save up a larger deposit.
“What you choose depends on your circumstances,” explains John. “LMI usually adds between 1.5% and 3.5% to your loan amount. If property prices go up more than the amount you’ve added on, you can build equity that outweighs the cost of LMI. Otherwise, you might be better off waiting.”
Some lenders don’t require borrowers to take out LMI at all.
“There are new lenders in the market who will lend up to 100% of the purchase cost to borrowers,” John says. “They structure the loan so that 80% is at a comparable interest rate to the mainstream lenders, and then the extra 20% is at a highest interest rate. These can be great options for people with great earning capacity, like university graduates or people starting again after a divorce settlement.”
If you’re lower income, take a look at government-backed lenders. In South Australia, HomeStart will lend up to 97 or 98% of the total cost. In Western Australia, KeyStart does the same for borrowers with an income under a set threshold. In both cases, the interest rates are higher than elsewhere, but may be a foot in the door for borrowers who don’t meet the criteria for mainstream lenders.
Another option is a family guarantee. “This can work well for younger borrowers whose parents own one or more properties,” says John. “They put a property up as security for the lender, who accepts it instead of LMI. The new borrower doesn’t have to pay the extra, and when their LVR drops to 80% they can refinance without the guarantee.”
If you’re hoping to buy property but don’t have a 20% deposit, don’t despair. Talk to a home loan broker about your options. You might be surprised at how many choices you have.