At one point, it was almost impossible to get a loan without having at least 20 percent to put down. Lenders were simply unwilling to take on the risk. That attitude has evolved in the last decade with the expansion of the private mortgage insurance industry.

Private mortgage insurance (PMI) is a form of insurance that protects lenders in the event of a borrower default. Unlike most insurance, however, the premiums for PMI are not paid by the party receiving the protection. Instead, these premiums are paid by the borrower.

Borrowers who take out this insurance are normally required to keep paying premiums until they have paid on the principle long enough to build a significant amount of equity-in most cases 20 percent. Borrowers are also required to make steady payments during this build up of equity to show they are not a default risk.

The private mortgage insurance industry experienced a measure of bad press in the 90s after many errant lenders failed to let borrowers know they could cancel the insurance once the coverage was no longer necessary. This breakdown in communication resulted in millions of borrowers paying hundreds, and in some cases, thousands of dollars towards unnecessary insurance policies.

The fleecing led to new rules established by the Home Owners Protection Act (HPA) of 1998. This legislation requires that lenders notify borrowers about the right to cancel PMI insurance as soon as the right exists. The rules also offer additional protection to homeowners who have a good payment history and states that after the original debt has been reduced to 78 percent of the purchase price (or value), the PMI policy must be cancelled.

How PMI Has Affected the Housing Market

For some people, the idea of saving up enough money to put 20 percent down on a home was preposterous, especially in areas like California, Florida, Arizona, and Nevada, where home prices have far outpaced the wages of residents.

The invention and expansion of private mortgage insurance gave a leg up to individuals who stood no chance of saving enough of a down payment to achieve the dream of homeownership. When used in conjunction with the increasingly popular adjustable rate mortgage, it also gave borrowers a chance to buy into markets that they stood no chance of affording using traditional financing methods.

Assistance offered by PMI has been a blessing for some, but a nightmare for many. Coupled with low interest rates and other factors, the influx of new buyers helped to induce significant increases in home prices. Many sellers and developers saw hefty gains, and the real estate industry suddenly became a hot commodity. Everyone wanted a piece of the pie. Unfortunately, some people bit off more than they could chew.

Trillions in adjustable rate mortgages are set to adjust this year. Thanks to the bursting of the housing bubble, a large percentage of these people owe more than their homes are worth. They have no way to refinance, no way to sell and break even, and absolutely no chance of cancelling their private mortgage insurance in the near future.

How PMI Rates Indicate Bubble Risk

Homeowners aren't the only ones chomping at the bit as a result of the housing slowdown. The private mortgage insurance industry is also more than a little nervous. If borrowers paid inflated prices for their homes, which many did, and then later default, which many will, this leaves the insurer holding the risk and cutting checks to mortgage lenders all over the nation.

When risk increases, rates rise. And this is precisely what we are seeing in the private mortgage insurance industry.

At one point, borrowers were required to pay private mortgage insurance upfront at closing. In 1992, the price paid for a PMI policy was equal to 2.2 percent of the loan amount. While it was easier for borrowers to come up with this amount versus a down payment, PMI wasn't an attractive option to most buyers. This is why the payment structure changed several years ago, allowing borrowers to spread the cost of insurance coverage out through the life of the loan.

Rates also used to be set differently. Originally, there were two categories of borrowers: those who were an acceptable risk and those who weren't. Borrowers, who were considered an acceptable risk, paid a predetermined premium. This premium was not based on anything but the amount of the loan and the size of the down payment. In other words, high-risk borrowers with bad credit paid the same rate as low-risk borrowers with perfect credit.

Those in the industry saw the risk potential with this rate system when the number of sub-prime borrowers investing in the market increased. Risk potential was also affected when home prices began to skyrocket at the beginning of the boom. The result is a new rate model.

PMI rates are now determined by the size of the loan, the type of the loan, the loan-to-value ratio, the borrower's credit score, and interestingly enough, the property's location. Borrowers who live in a city with declining property values will now pay a much higher rate than those who live in a city with rising property values.

Parties who are interested in determining just how high the bubble risk is for certain areas of the country would do well to look at PMI rates. In times like these, mortgage insurers are putting their necks on the line with every policy they write. They anticipated the bubble before it started and now know the market as well as anyone, and in some cases, better than most.