PMI vs. Second Loan

Here’s how to weigh your options if you plan to buy a home with a down payment of less than 20 percent.

Homeowners who make a down payment of less than 20 percent are usually required to pay private mortgage insurance (PMI), because they are considered to be at higher risk of default. PMI premiums are typically around one-half of 1 of the purchase price of the home, which is about $125 a month on a $300,000 mortgage.

Seconds (or second loans) were created as an alternative to this extra expense. With this strategy, the homeowner makes a 5 or 10 percent down payment, gets a mortgage for 80 percent of the home’s value, and then takes out a second loan for the remaining 10 or 15  percent. Because no single loan exceeds 80 percent of the property’s value, PMI isn’t required. The combined payment of the two loans may be less than the cost of a single mortgage plus PMI, especially since the interest on the second loan may be tax-deductible.

In recent years, second loans — which are sometimes structured as home equity lines of credit — were so attractive that mortgage insurance companies were losing customers in droves. But a federal law allowing some taxpayers who buy a home in 2007 or later to deduct PMI premiums is evening the playing field. This change has closed the price gap between the two options.

For example, let’s say you’re purchasing a $250,000 home with a down payment of 10 percent and have opted for a 30-year fixed-rate mortgage at 5.75 percent.

Here’s how your choices might look:

Option 1: You take out a mortgage for 90% of the home’s value ($225,000) and pay PMI.

Mortgage payment: $1,313.04
PMI premium (0.5%): $93.75
Total monthly payment: $1,406.79

Option 2: You take out a mortgage for 80% of the home’s value ($200,000), plus a  second loan for the other $25,000.

Mortgage payment: $1,167.15
Piggyback loan payment (8.5%): $192.23
Total monthly payment: $1,359.38

In this case, the monthly payment is almost $48 lower with Option 2, though the  second loan may carry origination fees that add to the cost of this option. In addition, if you are able to claim your PMI premiums, you may be able to get a larger tax deduction with Option 1. A small change in any of the interest rates used in this example can also tip the balance in the other direction.

A few caveats about the law, which companies selling PMI have long lobbied for. It allows taxpayers to deduct PMI premiums as long as their adjusted gross income is $100,000 or less. It applies only to people who purchased a home in 2007 or thereafter. It is unclear whether or not the law will be extended beyond 2020. If you’re already paying premiums on an existing mortgage, you can’t claim the deduction.

The second mortgage in an 80-10-10 loan is usually a home equity line of credit, or HELOC. For people with credit scores of 740 or higher, 80-10-10 loans often cost less than traditional loans with mortgage insurance during the first 10 years while the HELOC is interest-only. The 80-10-10 advantage narrows for people with lower credit scores because of the higher interest rates they are charged.

If you’re planning to buy a home with a down payment of less than 20 percent, talk to an accountant or tax adviser who can help you determine which option is the least expensive in your particular situation.

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