PMI is used by mortgage lenders to help cover their losses in case of default. Lenders typically require borrowers to purchase PMI if their down payment is less than 20%. Loan agreements often let borrowers cancel PMI once the home’s equity exceeds 20% of its original market value. Nonetheless, says Longhofer, many borrowers who could cancel their PMI fail to do so, presumably because they are unaware of this option.
The pending legislation would require loan servicers to notify borrowers--both at the time the loan is originated and annually thereafter--of their right to cancel PMI once they have sufficient equity. The bill would also require lenders to cancel PMI automatically once the borrower’s principal balance falls below 75% (80% in the Senate bill) of the home’s original value.
Writing in a recent Economic Commentary, Longhofer says Congress’ solution may not deliver the "fairness" it intends. He explains that forcing PMI cancellation at a government-set equity level, rather than one determined competitively in the market, results in two distortions: First, it would limit lenders’ ability to require PMI for those they deem most likely to default. As a consequence, some high-risk borrowers will be unable to obtain mortgages.
Second, basing cancellation on the original value of the home (instead of current market value) would raise the average riskiness of mortgages by forcing cancellation of PMI even if the home’s market value had dropped so much that the borrower’s equity was less than it was when the mortgage was originated.
Longhofer also points out that PMI reform would impose new costs on lenders which would likely be passed on to borrowers in the form of higher mortgage rates and fees. Furthermore, while some borrowers would gain from the mandatory notification and automatic PMI cancellation, says Longhofer, the number is far fewer than what proponents of the legislation suggest.
Longhofer concludes that Congress should consider all of the ramifications of PMI reform before it acts. Too often, he says, consumer protections hurt the very people they are supposed to benefit.
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