Saving a 20% deposit is often considered the ‘gold standard’ for purchasing a home in Australia. But with rising living costs and rapidly increasing property prices, many buyers struggle to reach that benchmark; often delaying their entry into the market for years. This is where loan mortgage insurance (LMI) comes in, as a key mechanism that allows buyers to enter the property market sooner, even with a smaller deposit. While it comes at an extra cost, loan mortgage insurance can be a powerful tool for those who want to stop renting and start building equity sooner.
What is loan mortgage insurance (LMI)?
Loan mortgage insurance is a specialised insurance that a lender purchases to insure itself against the possibility of not recovering the full outstanding loan balance should the borrower be unable to meet their repayment obligations, leading to the sale of the property. It serves a crucial role in mitigating risk for lenders while facilitating earlier entry into the property market for prospective homeowners.
The standard loan mortgage insurance policy is a one-off, non-refundable, non-transferrable premium that is typically added to the home loan. The cost of this premium is borne by the borrower. However, despite the borrower paying the cost, loan mortgage insurance is designed to protect the bank or lender (such as CommBank, Westpac, or Bankwest) against potential losses associated with providing a low-deposit home loan. This protection ensures that the lender is covered for any loss they may incur if the borrower defaults.
If a borrower defaults and the property is sold for less than the outstanding loan balance (known as a shortfall), loan mortgage insurance covers the lender for that loss. Importantly:
- Loan mortgage insurance does not protect the borrower.
- The borrower is required to pay the loan mortgage insurance premium.
- The insurer can recover the shortfall amount from the borrower after paying the lender.
Loan mortgage insurance is often confused with Mortgage Protection Insurance (MPI), which is taken out by the borrower to protect their own ability to make repayments in the event of death, disability, unemployment or reduced income. They are not the same.
When is loan mortgage insurance required?
Loan mortgage insurance is generally required when a home loan presents an increased level of risk to the lender. The key determinant for whether loan mortgage insurance applies is the Loan-to-Value Ratio (LVR).
Lenders typically require a deposit equivalent to 20% of the property’s value. If a borrower is unable to provide this substantial deposit, their LVR will be above 80%, and loan mortgage insurance is usually required. This requirement stems from the fact that loans originated with an LVR of 80 per cent or greater have a higher risk profile.
For example, if you buy a $500,000 home:
- A 20% deposit = $100,000 (no loan mortgage insurance required)
- A 10% deposit = $50,000 (loan mortgage insurance will normally apply)
Loan mortgage insurance may also apply when:
- Refinancing your home loan;
- Topping up or restructuring your home loan, or
- Borrowing additional funds that increase risk to the lender.
Even when LMI is required, lenders still apply their own credit assessments. Loan mortgage insurance does not guarantee finance approval.
How loan mortgage insurance helps buyers enter the market sooner
While loan mortgage insurance primarily protects the lender, its function of reducing the lender’s risk profile provides significant benefits to individuals who have not yet accumulated a substantial deposit. By utilising LMI, lenders are made more likely to lend even without a 20% deposit.
The primary advantage for the borrower is the ability to enter the property market sooner. By taking out a home loan with a smaller deposit, lender mortgage insurance helps people buy homes who otherwise might find it difficult to obtain mortgage finance.
This early entry allows the borrower to stop paying rent and immediately start growing equity in a home. Furthermore, relying on LMI may negate the need for the borrower to seek guarantor support—where a family member mortgages their own property as additional security—to secure the loan.
The financial benefit of acting sooner can be substantial, particularly in a market characterised by rising property values. As illustrated by one example, if a borrower waits an additional two years to save a larger deposit, the premium saved by avoiding lenders mortgage insurance might be far less than the increased cost of the property due to market appreciation.
For instance, a borrower who pays a lenders mortgage insurance premium of $8,700 to buy a $500,000 property immediately could find themselves $42,550 better off two years later if the property value climbs to $551,250, even accounting for the loan mortgage insurance cost.
How much does loan mortgage insurance cost?
The calculation of the loan mortgage insurance premium is complex, varying based on several factors, including the LVR, the total size of the loan, the property’s value, the size of the borrower’s deposit, and the specific policies of the lender.
A general rule is that the more the borrower contributes to the purchase price, the lower the loan mortgage insurance cost will be. Generally, LMI costs can range between 1% and 5% of the total loan amount. For instance, a $500,000 loan with only a 10% deposit might incur loan mortgage insurance costs exceeding $10,000.
The loan mortgage insurance premium depends on:
- Your deposit size;
- The loan amount;
- The property value; and
- The lender’s own risk criteria.
The process of payment involves the lender paying the LMI premium to the insurer at the settlement of the home purchase. This is a once-off, up-front payment that covers the lender for the life of the loan. The lender then passes the cost of this premium onto the borrower as a fee, as it is considered part of the cost of providing loan finance. Lenders typically do not receive a commission on the loan mortgage insurance they pass on.
Borrowers usually have options for how to manage this cost:
- Upfront Payment: The premium can be paid immediately as part of the upfront costs at settlement;
- Capitalisation: The premium can be capitalised, meaning it is added to the total home loan amount. If the premium is capitalised, the borrower must be aware that they will pay interest on the premium over the agreed contracted loan term, which increases the long-term cost of the loan.
While loan mortgage insurance is often described as non-refundable, partial refunds of the premium paid may be eligible in certain situations if the loan is repaid in full and the associated mortgage is discharged early.
For example, a 40% refund may apply if the loan is paid off within 12 months of settlement, or a 20% refund if paid off between 12 and 24 months, provided the loan has not been in arrears and the calculated refund exceeds a minimum threshold (stamp duty is not refundable).
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The risk to the borrower: default and shortfall debt
The critical drawback of LMI for the borrower lies in the risk transfer mechanism used during a default scenario. If a borrower is unable to meet their loan repayments, the lender may assist in the sale of the property. If the proceeds from this sale are insufficient to pay off the loan in full, a “shortfall” debt remains.
The borrower (and any guarantor) remains legally obligated to repay this outstanding shortfall amount. The loan mortgage insurance insurer steps in to cover this loss for the lender, paying the shortfall amount to the bank. However, once the loan mortgage insurance insurer compensates the lender, they then acquire the right to seek repayment of that shortfall debt directly from the borrower.
- Expert Tip
For example, if a borrower defaults on a $500,000 loan, and the repossessed home is sold for $450,000, the resulting shortfall is $50,000. The loan mortgage insurance insurer would pay the lender the $50,000 shortfall, and then the insurer has the right to seek repayment of that $50,000 from the borrower.
If the borrower experiences financial hardship following a default (e.g., due to job loss), LMI insurers recognise the difficulty in immediate repayment and have hardship policies in place, allowing for possible arrangements like a deferral or an instalment payment plan.
Alternatives to loan mortgage insurance: other low deposit options
Lenders may offer several alternatives or complementary options for prospective buyers who lack a large deposit. These options include:
- Low Deposit Premium (LDP): Similar in function to loan mortgage insurance, this is an additional cost that helps secure a home loan with a smaller deposit. If a borrower is asked to pay loan mortgage insurance, they generally will not be asked to pay an LDP.
- Guarantor support: A family member can provide assistance by mortgaging their own property as supplementary security for the loan.
- Property share: This option allows individuals to split the cost of a home with family or friends while maintaining individual control over their respective finances.
- Australian Government 5% Deposit Scheme: This scheme can enable first home buyers to purchase a home with a deposit as low as 5%, as the government may act as a guarantor for the remaining deposit needed to reach the 20% threshold, meaning loan mortgage insurance does not apply.
Each option carries its own requirements, risks and obligations. Speaking with a home lending specialist and your property conveyancer is essential to determine the best fit for your financial situation.
Important considerations before choosing loan mortgage insurance
- Budget for the cost of loan mortgage insurance, particularly if you plan to capitalise it.
- Ensure you understand that loan mortgage insurance does not protect you, only the lender.
- Consider the long-term interest impact if adding loan mortgage insurance to your loan.
- Compare the cost of loan mortgage insurance today against the cost of waiting years to save a larger deposit.
- Seek advice early – finance delays and deposit shortfalls can jeopardise contracts.
Regulatory and industry context
The extensive use of loan mortgage insurance influences financial stability, given its deep involvement in the credit creation process and its links with the banking system. In Australia, loan mortgage insurance is widespread, estimated to cover more than one-quarter of all housing loans.
Australian loan mortgage insurance providers are unique internationally because they are privately owned and operate without government guarantees. This differs from jurisdictions like Canada and the United States, where government participation is substantial.
LMI insurers face significant insurance risk because their liabilities are concentrated in highly correlated risks; unlike general insurers, they can experience a large number of claims simultaneously during economic downturns.
To manage this concentration risk and ring-fence mortgage insurance from other insurance activities, the Australian Prudential Regulation Authority (APRA) requires LMI providers to be ‘monoline’ insurers. APRA further requires Australian LMIs to hold a substantial amount of capital specifically against this ‘insurance concentration risk’ to ensure they can withstand a severe housing market downturn.
From a stability perspective, LMIs can help temper swings in lending standards. During periods of rising risk appetite among lenders, LMIs provide a “second set of eyes” in the loan origination process, which can help limit the extent to which lending standards weaken.
Conversely, during economic downturns when risk appetite subsides, a well-capitalised LMI industry can help smooth changes in lending standards by increasing some lenders’ willingness to continue writing high-LVR loans. However, the use of LMI does not guarantee a moderation of the credit cycle, as some lenders might relax their own standards, assuming any loss will be transferred to the LMI.
The complexity of LMI necessitates seeking professional guidance. Borrowers can seek indicative LMI quotes using lender calculators or speak to home lending specialists to fully understand when LMI may apply, its specific cost, and the implications of a shortfall debt.
Loan mortgage insurance acts like a safety net strung beneath a high-wire act: the high-wire act is the risky, high-LVR home loan, and the safety net is for the lender. The borrower, while performing the act, pays for the net, which allows them to start sooner, but if they fall, the net catches the lender’s loss and immediately swings the bill for the safety net back to the borrower.
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