Our mortgage department has a program for PMI where if the borrower meets certain criteria (i.e., credit score, etc.), the Bank can pay the single premium pmi at a lesser cost. So, for example, if the pmi ends up being $2500.00, they are showing on the settlement statement, the borrower paying a $2500.00 fee to the bank under the loan discount (line 802) and then the PMI premium of $2500.00 to the PMI company on line 902 as p.o.c. The $2500.00 is being disclosed as a prepaid finance charge on the TIL.

Is this the correct way to show the PMI? And, for tax reporting purposes, would we show the $2500 on the year end 1098 because it's disclosed as a loan discount fee? It just doesn't seem quite right to me.

Sounds like a good shell game to me.

The mortgage dept decided to pass along the exact cost of the mortgage insurance instead of increasing the rate on the loan. Can someone please tell me if they have heard of this or if it's even allowed?

Well, then it truly is not "lender paid". However, the way you described it is that you are charging them an origination fee that will just offset the cost. I would not label it a "discount fee" as a discount fee is typically a charge that the borrower pays to get a a lower rate (thus a discount fee).

Does this practice create a tax advantage the borrower wouldn't enjoy if the PMI premiums were charged directly?

That is why I originally called it a shell game.