The Pros and Cons of Private Mortgage Insurance (PMI)

Private mortgage insurance.

Many prospective applicants for home loans believe this is a bum deal. Not so, says MarketWatch — although it definitely has its pros and cons.

For almost a half century, private mortgage insurance, or PMI, has been a necessary evil for any prospective homeowner who is unable to accumulate the requisite 20 percent down payment on a home loan that makes lenders comfortable.

Studies show that borrowers who put up less than 20 percent of the purchase price are far more likely to default and go into foreclosure than those who have more of their own money riding on the deal. And lenders abide by that stat.

Enter PMI, which assumes part of the extra risk lenders take in making a mortgage with less than 20 percent down. If you should fail to make your payments and the lender is forced to foreclose, the company will cover part of the lender’s loss.

Of course, this doesn’t come without a cost. PMI can add up to a couple of hundred dollars a month to your house payment. And the insurance is in place to protect the mortgage lender, not you.

Still, thanks to mortgage insurance, which was invented in 1957, millions of folks — 1.5 million alone in the last 12 months — have become owners of houses, many with as little as 3 percent of the purchase price coming from their own funds.

There are alternatives. One is to wait until you accumulate enough cash for a 20 percent down payment. Another is attempt to secure a low down-payment loan insured by the Federal Housing Administration (FHA). And yet another is to seek a subprime lender who doesn’t require insurance.

The drawbacks? It could take years to scrape together enough cash to avoid PMI. An FHA mortgage is more expensive than those backed by private companies and subprime loans are even more costly than that.

Several years ago, people tried another strategy: Take out another mortgage to cover the difference between the amount of cash they had on hand for a down payment and 80 percent of the purchase price.

In simple terms, if the mortgage was for $100,000 and you had only $10,000, you would take a second lien for the difference, or $10,000.

In some cases, but especially when mortgage rates were so low, this maneuver, also known as “piggyback” or “combination” loans, was actually less expensive than PMI. But it, too, has shortcomings. And in some cases, it’s not the cheapest choice.

In some instances, combo loans may save borrowers money, but they also make the lenders who tout them make more money, too. According to one analysis, lenders prefer piggyback loans because they “earn additional revenue” on the second mortgage portion of the loan, which carries higher interest.

The most creditworthy borrower can sometimes secure the second lien, for perhaps “only” two percentage points more than what they pay on the first mortgage. But for anyone else, rates can be up to six points higher.

Another point to consider is that since these combo loans already include a second home mortgage, you are pretty much precluded from taking out a home equity loan or line of credit once you build up some value.

The piggybacked second lien of some combo loans, though, are in the form of a home equity line of credit, so you may be able to borrow more against your house as you repay the loan and you continue to build equity through appreciation. And, naturally, you can always scrap the entire thing by refinancing to get at your equity. But refinancing a combo loan could be a lot more complicated. And costly.

Another sticking point is that the second-lien portion of a piggyback loan is often adjustable, which means your payments could go up if mortgage rates increase. Furthermore, some piggyback loans are 15-year balloon mortgages with 30-year amortization schedules.

Therefore, at the end of the 15-year payback period, you could be left with a big payment, and you may be forced to refinance at a time when interest rates aren’t nearly as friendly.

Those are the negatives.

On the plus side, interest paid on a second mortgage is tax deductible. The money you pay for mortgage insurance can’t be written off, but Congress is considering a trial program that would make premiums on both private and government insurance a tax deduction for those earning under $100,000, at least for 2007.

Also, if you should sell or go through the home mortgage loan refinance process within the first 15 years of the loan, you’ll get a refund for the unused premium. The longer you’ve held the loan, the lower the refund. But if you give back the loan within, say, five years, you can expect a rebate of anywhere from 33-50 percent.

Finally, private mortgage insurance can be canceled once your equity has reached a certain level. Your lender may put you through the wringer before allowing you to drop coverage, and you’ll almost certainly have to pay $300 or so for a new appraisal. But the only way you can end the 10 percent 2nd mortgage is to pay it off.