Mortgage Insurance vs. A Piggyback Mortgage: A Case Study

Buyers are sometimes torn about how much money to put down a house. Drop too much and you’re in danger of lacking any sort of financial cushion in case of emergency.

Not enough, and you need to either take out a private mortgage insurance (PMI) policy; or, borrow with a piggyback mortgage - consistsing, for example, of one 30-year fixed-rate mortgage that covers 80% of the cost of the home and a second 15-year fixed-rate balloon loan to cover 15% of the down payment.

Let’s run through the potential benefits and drawbacks of each loan.

Piggyback mortgages grew in popularity when mortgage and interest rates were low. But after the Fed began incrementally raising short-term rates, these loans became too expensive for some borrowers, says Keith Gumbinger, spokesman for New Jersey mortgage-data publisher HSH Associates.

This year buyers have another reason to avoid piggyback mortgages. Piggybacks used to be more attractive than traditional loans because mortgage interest on the second loan was tax-deductible, while PMI premiums weren’t. But under a new federal law passed late last year, PMI premiums are tax-deductible for borrowers who buy or refinance a home in 2007.

There are eligibility requirements: A homeowner must have an adjusted gross income of $100,000 or less to get the full deduction. Above $100,000 the deduction begins to phase out - borrowers with AGIs of $110,000 ($55,000 for married people filing separately) or more get nothing. The deduction also doesn’t apply to mortgage-insurance contracts issued before Jan. 1, 2007.

Higher rates and the new tax break appear to be prompting more borrowers to choose loans with PMI. The number of home buyers opting for such mortgage loans rose to 108,980 in February, up 20% from a year earlier, according to the trade group Mortgage Insurance Companies of America.

So, does it make sense for to pay PMI?

Mr. Gumbinger of HSH ran the numbers to see how the two loans compare at today’s rates. On a piggyback loan - 80% financed with first loan, 15% down payment financed with 2nd mortgage, 5% down payment from savings, no PMI - Melissa and Joe would pay $1,236.64 in principal and interest on a $200,000 30-year fixed rate mortgage at 6.29%.

On the second loan - a $37,500 20-year loan at 8.15% - they’d pay $317.17 a month in principal and interest. So their total monthly payment would be $1,553.81.

On a $237,500, 30-year fixed-rate mortgage with PMI (95% financed, 5% down) at 6.29%, their monthly payment would be $1,468.51 and PMI would cost an additional $154.38, for a total estimated monthly payment of $1,622.89 - or about $69 more a month than the traditional loan. Now factor in the PMI tax deduction: $39 a month, assuming a 25% tax bracket, according to this calculator from PMI Group Inc.

But there are other reasons to pay PMI:

With a piggyback mortgage, the only way to lower the monthly payment is to pay off the second loan or to refinance when home mortgage rates fall. Refinancing costs average between 3% and 6% of the outstanding principal, with the highest rate being paid by homeowners with bad credit.

PMI premiums, on the other hand, will eventually go away. Borrowers have the right to ask lenders to end the premiums once the loan’s balance falls to 80% of the home’s fair market value. But there is a cost involved - homeowners must hire an appraiser, which can cost between $250 to $350, depending on where you live.

The iffy housing market also may mean your home will appreciate in value much more slowly than in recent years, or may even decline, forcing you to make premium payments for much longer than the five to seven years homeowners typically pay for PMI. “With the position the housing markets are in today, it’s much more of a crapshoot than it was before,” says HSH’s Mr. Gumbinger.

Because piggyback loans generate a larger tax deduction than single loans, they’re generally best for borrowers in the highest tax bracket, according to Jack Guttentag, professor emeritus at the University of Pennsylvania’s Wharton School. Piggybacks are least attractive for low-income borrowers - the bigger the house, the bigger the bad credit mortgage and the bigger the tax deduction.

If you plan on living in the home for five to seven years. Mr. Guttentag says it makes more sense to choose a loan with PMI: “The borrower might be able to get rid of mortgage insurance after six or seven years - not so with a [big] second mortgage.”

SOURCE: Real Estate Journal