Why would any mortgage shopper want to pay for default insurance if they don’t need it?
The answer, unintuitively, is to save money.
For the uninitiated, homebuyers taking out a mortgage with less than a 20 per cent down payment must purchase transactional insurance to protect the lender in case of default. This insurance reduces the lender’s risk and lowers its mortgage funding costs, which lets it offer lower rates.
Those who make a down payment of 20 per cent or more can obtain an uninsured mortgage. Because the lender incurs more risk and costs on uninsured mortgages, they charge a higher rate. The advantage is that the borrower doesn’t have to pay for insurance, so it’s usually a better deal overall.
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But that’s not always the case any more.
“Right now, for buyers purchasing properties under $1-million, it’s often cheaper to get an insured mortgage rate and pay CMHC insurance than to get uninsured rates,” says Community Savings Credit Union CEO Mike Schilling.
“It’s counterintuitive and has taken the buyers I’ve been speaking with by surprise,” Mr. Schilling says. “In our rates meeting last week, one of our lenders said they hadn’t seen this situation before in all their years of lending.”
How (and why) this insurance strategy works
The difference – also known as the “spread” – between insured and uninsured five-year mortgage rates used to be 20 basis points or less. (A basis point is 1/100th of a percentage point.)
But now, for reasons related to lender capital constraints, mortgage securitization (where lenders sell pools of mortgages to investors), risk aversion and lenders’ desire to attract first-time buyers, five-year insured-uninsured spreads have ballooned out to 55 to 90 basis points, depending on the lender.
For borrowers who are purchasing a home or switching lenders with more than 20 per cent equity, it’s sometimes cheaper to pay the default insurance premium than it is to pay a higher uninsured mortgage rate.
Here’s a simple example:
Assume you have a $100,000 mortgage and 25 per cent home equity. The lowest nationally advertised five-year fixed rates are currently 5.79 per cent (uninsured) and 5.24 per cent (insured).
That insured rate represents a $2,254 savings over five years. The transactional insurance costs $1,700 (plus PST in some provinces), so you’re roughly $500 ahead per $100,000 borrowed over five years.
The key to this manoeuvre is that you must meet default insurance qualifications. Among other things, that means:
- Your home must be valued under $1-million, or it must have been at the time you purchased it;
- Your amortization must be 25 years or less, or you must reduce it to 25 years;
- Your credit score must be 600 or higher;
- Your ratio of debt-to-income must meet insurer guidelines (e.g., your total monthly debt and housing payments – as calculated by the lender – must be less than 44 per cent of your gross monthly income).
What about insurable rates?
There’s also a type of mortgage called an “insurable” mortgage. (Note that this is different than transactionally “insured” mortgage.) This is where you have 20 per cent or more equity, and the lender buys the insurance for you. Insurable rates are usually lower than uninsured rates, but they’re still higher than transactionally insured rates.
In this case, paying for insurance yourself might still make sense. It might cost you a few hundred bucks per $100,000 borrowed, but having a default-insured mortgage can save you a wad of money at renewal – given insured renewal rates are usually the lowest rates in Canada.
What to watch out for
Buying insurance to get a lower rate does not make sense if you refinance the entire mortgage or buy a $1-million-plus home before you recoup the insurance cost. In those cases, you could lose your low insured mortgage rate. That’s something to consider, given that recouping your cost could take roughly 2.5 to 7.5 years, depending on the situation.
That said, if you ever need to borrow more, you can potentially add a HELOC behind your insured mortgage and keep the low insured rate intact, even if you renew with a different lender after that.
Also, the strategy doesn’t work as well on terms of less than five years – like a one- or two-year fixed – unless you’ll have the mortgage for a long time. That’s because you must allow enough time for the rate savings to recoup the default insurance cost.
On a side note, most borrowers roll the default insurance premium into the mortgage, so there’s no out-of-pocket cost.
The takeaway
If you have 20 per cent equity or more, want a longer-term mortgage and meet the above criteria, ask a mortgage broker or lender to run the math to see if you’re better off paying for default insurance based on the best rates available.
Often, the best available rates are found in different channels. For example, you might get the lowest insured rate from a mortgage broker and the lowest uninsured rate directly from a lender. So you may have to talk to a few different people.
In the event this extra legwork results in savings over your next couple of mortgages, the effort will be worth it.
Just keep in mind this strategy won’t work forever. “I think the insured-uninsured spread will shrink,” Mr. Schilling says. “It’s likely a passing trend that may correct by next year.”
Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.
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