The number of property buyers taking out lenders' mortgage insurance is soaring, but just who does that insure?

An alarming number of borrowers do not understand that after the bank gets paid out, they could still be left hundreds and thousands of dollars in debt to the insurer, should anything go wrong.

With interest rates destined to rise and house price growth expected to ease, many borrowers could find themselves in much more trouble than they bargained for.

In 2006, Luke (who asked that we not publish his surname) was climbing the corporate ladder. He bought an investment holiday unit on the New South Wales mid-north coast as well as a family home.

However, as the global financial crisis hit, he was made redundant.

"In 2012, we were no longer able to service the investment property loan and the bank involved took mortgagee-in-possession of that property," he said.

Luke was not too worried because he had lenders' mortgage insurance, or LMI.

"What we understood was that it was there to enable the bank to lend money under circumstances where there was not a 20 per cent deposit on the property," he explained.

"We understood that even though we were the policy holder to the mortgage insurer, it was for the benefit of the bank."

Widespread LMI misunderstanding

Luke believed correctly that the insurer would pay the bank in the event of default.

What he did not realise was that the insurer would then chase him for the money, which is several hundred thousand dollars.

"It's left us in dire straits. It's a very difficult situation," he added.

Luke is not alone.

"Many of the people who take lenders' mortgage insurance are not clear what precisely they are covered for," said independent bank analyst Martin North, the principal of Digital Finance Analytics.

His survey of 26,000 borrowers found less than a third knew that the policy protects the bank in a default, not the borrower. Roughly the same again are unsure.

Almost half wrongly believe it protects them, and that figure is even higher for first home buyers.

"Some of them could be living with a bit of a false sense of security and, of course, until things go wrong, it's not really tested," he added.

Up to a fifth of borrowers to struggle with 'normal' rates

Mr North's research reveals that things could go very wrong.

"My modelling suggests that if interest rates were to rise by 1.5 to 2 per cent, back to a more normal level, then between 15 and 20 per cent of borrowers would actually start to get into some difficulty," he warned.

There are an estimated one million LMI policies now in Australia.

Soaring house prices have meant many borrowers do not have the 20 per cent deposit needed for a loan, so they are forced to take out a policy if they want to buy.

The chief executive of the CUA credit union Chris Whitehead says his institution uses LMI to protect it from losses.

"We require loans - most loans over 80 per cent - to have LMI," he said.

"That's very much to manage the risk. The closer you get to the value of the property, clearly, the risk of a loss does increase."

The number of low deposit loans has, on average, been falling since the GFC.

However, not at credit unions. Australia's biggest credit union says it is not concerned.

"Credit unions are here to help people get a home and we do so prudently," Mr Whitehead added.

LMI may encourage risky lending

It has got regulators on edge, warning about lending risks. Credit unions, like many other institutions, believe LMIs offset that risk.

"What it does is provide a greater level of security and that enables us to lend more to people," Mr Whitehead argued.

Martin North is concerned that LMI is allowing banks to relax lending standards.

"Some lenders are a little more willing to countenance a higher lender value loan simply because of the mortgage insurance," he cautioned.

There are only two approved LMI providers in Australia: QBE LMI and Genworth. Both declined an interview.

Luke cautions buyers against taking out lenders' mortgage insurance.

"Definitely not, don't do it. And as soon as you come under stress, both the bank and the mortgage insurer will be knocking on your door," he warned.

The paid protection for the banks leaves borrowers exposed.