Note to Lenders: New estimates please!

Anybody who's purchased a home will tell you that its a frustrating thing to have to come up with more money than expected when its time to close escrow. Although there are many causes for a closing cost estimate to be incorrect, one common issue is an inaccurate estimate for homeowners insurance.

When you get a loan, the lender will typically take the loan amount and multiply by a factor (what I'll now refer to as the 'guestimated insurance factor') ... to give you an estimated insurance cost. It has nothing to do with the house itself. No accounting for the twenty year old wood shake roof, the trampoline in the back, or the custom kitchen you are installing. Just a simple, cookie-cutter mathematical formula.

Lets look at how that might work on a basic deal. Lets say your house needs to be insured for $400,000. It might have a loan on it for $450,000 (your house price) X .002 (the 'guestimated insurance factor' used by the lender) = $900 (the estimate on your homeowners that is calculated in to your closing cost estimate). Let's say for our example's sake that the $900 estimate is spot on.

So here is the thing. From 2000 - 2007, we've seen the loan amounts on California real estate skyrocket ... before now dropping. During the first year of that spike in real estate prices, new clients would be happily surprised to find that their actual insurance costs were significantly less than the estimate. Let's use the same example above with an inflated home price / loan value. The same house would now have a loan for $650,000 X .002 = $1300 as an estimate for insurance, a difference of $400 from the original example. The client would be thrilled to hear that our policy was only $900!

However, lenders soon realized that the figures they were using didn't account for the inflated purchase prices / loan amounts. They want their figures accurate to qualify the borrower for the best / largest loan possible. Leaving $400 on the table annually didn't allow them to do that. SO, they dropped their 'guestimated insurance factor' to get their numbers more accurate. So now, instead of using .002, they changed their calculations to use .00138. The same house above with the same inflated loan amount of $650,000, with just a slight change to the 'guestimated insurance factor' would yield a more accurate rate of $900. $650,000 X .00138 = $900! Viola!

Problem is ... now the values have dropped on homes, resulting in lower loan amounts than before. Now our house that needs to be insured for $400,000 is only selling for $400,000. The mortgage folks are using the same 'guestimated insurance factor' (.00138 in my example), ... and the result? Our client is unpleasantly surprised to discover that his estimate is off. The lender calculated $400,000 (lower loan value here in Q3, 2008) X .00138 = $554. Thats $350 lower than the actual $900 premium ... which makes an unhappy borrower at escrow closing time.

All that to say ... "Lenders, its time to update your insurance estimates."