What it is:
How it works (Example):
Mortgage lenders assume a high degree of risk in connection with home loans. For this reason, lenders frequently purchase mortgage insurance plans. These are policies that compensate mortgage lenders for losses caused by payment delinquency as well as the death or debilitation of the borrower. For example, if the borrower for a $100,000 mortgage dies leaving a $40,000 balance on the mortgage, the lender's mortgage insurance covers the unpaid $40,000.
Lender's may also require borrower's to buy mortgage insurance (called private mortgage insurance, or PMI) when the borrower's down payment is less than 20% of the home's purchase price. Once equity in the house reaches 20%, the lender will drop the requirement.
Why it Matters:
Numerous insurance companies suffered and even folded because of the high number of claims on mortgage insurance policies during the subprime mortgage crisis of the late 2000s. The magnitude of the problem warranted the U.S. Treasury to intervene and lend emergency funds in order to curb the effects on the financial system.