Premiums and Mortgage Insurance

Before we start this week’s post, I’m pleased to announce that Brayden Cleland has accepted a full-time position at Ridgeview Financial Planning as my assistant. Brayden has earned a degree in finance and will be starting his Certified Financial Planner studies in the coming weeks. Welcome, Brayden!

Also, I took our new website live this week. The format is more mobile friendly, and I’ve updated some of the content. The links you might have used the in the past (logging into your portal, sending documents securely, etc) will now be found in the “Clients” dropdown list on the homepage.

This week let’s review two more finance terms from the YouGov poll: premium and mortgage insurance. Like last week, I’m wondering if folks know of the terms but don’t necessarily understand the details. For example, most people know what a premium is because they pay it. But do they understand how premiums differ from deductibles and the associated tradeoffs?

This post will address those sorts of details as succinctly as possible, even though whole chapters of a book could be devoted to them.

Premium – “Premium” has multiple uses within the realm of personal finance. For example, investors may pay a premium to buy a higher-quality stock or bond, and there are “term premiums” that investors want to receive when buying longer-term bonds. There are many examples in this vein, but this week let’s focus on “premium” as it pertains to insurance and the tradeoffs that come into play.

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 When we pay premiums to an insurance company, we’re not simply writing checks, we’re making choices about risk.

For example, say a health insurance company offers two premium/coverage combinations. One costs $375 per month and has a $6,000 annual deductible. The other costs $600 per month but doesn’t have a deductible. Which should you choose? The answer is all about how you view your premium dollars and the concept of risk.

If you were risk averse, you’d likely opt to pay the higher premium, in this case $7,200 per year. You’re comfortable (so to speak) with paying higher ongoing costs so you don’t have to “worry” about the risk of unexpected deductible-related bills. These higher premiums really add up over time but can also make sense if you use your insurance regularly.

But if you’re more of a risk taker, you’d likely opt for the lower premium, higher deductible option. Your annual premium cost would be $4,500, or $2,700 less than the no-deductible option. Sounds cheaper, right? It is, but you’re essentially making a bet with the insurance company that you won’t need much medical care in the coming year and are looking to pocket the extra cash not spent on premiums.

You’d win the bet if you went multiple years needing little to no care. But if you did need a good amount of care, the insurance company wins, to the tune of $10,500, your premium costs plus your annual deductible.

Recall the old saying about there being no free lunches. If you want more flexibility by paying lower premiums, you’ll be taking on more risk. If you want more piece of mind, you’ll pay for that too; a premium on your premium, so to speak.

Mortgage Insurance – Mortgage insurance exists to cover lenders if the borrower (you, for example) can’t repay the loan and goes into default. Maybe you were buying your first home and couldn’t afford the typical 20% of the purchase price as a down payment. The lender might be willing to lend you the money so long as you help them reduce their risk. Since paying extra cash up front obviously isn’t an option, you pay a premium (there’s that term again) along the way until you’re deemed less risky.

While mortgage insurance can be helpful in getting into your first home, it gets expensive over time. The average cost is from about 0.5% to 1% per year of the loan amount. Considering the average house price in Sonoma County, you could be paying enough extra on your mortgage each month to lease a Tesla!

Mortgage insurance can drop off according to a predetermined schedule or you can prove your home’s value has increased sufficiently by paying for an appraisal. Until then, you’ll be stuck paying extra until you at least have 20% equity (current house value less your current loan amount) in your home. If you put down a minimal amount, say 5%, this might take a while. Oh, and mortgage insurance premiums aren’t tax deductible anymore either.

So, mortgage insurance is all cost with the only benefit being that you get to be a homeowner sooner rather than later. In the grand scheme of things paying mortgage insurance could still be reasonable option. But the devil is in the details and proper planning is critical to ensure you’re not overextending yourself.

Here’s a link to a summary of the YouGov poll:

https://today.yougov.com/topics/finance/articles-reports/2018/02/27/americans-confident-financial-terms-mean

Have questions? Ask me. I can help.

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