Mortgage Articles – For the smart consumer

Second Mortgage Versus PMI
As a homebuyer, you may be faced with a situation that many other people have dealt with before you.  You lender’s looming 20% down-payment requirement does not have to mean the end of the road for your home purchase.

If you have researched several mortgage programs and talked to multiple potential lenders, you probably already realize that most mortgages are set up to cover only 80% of the cost of your new home, leaving you with the need to pay the other 20% at closing.

But not all buyers are prepared to make a 20% down payment on their new home.  Fortunately, borrowers have other options for making the dream of homeownership a reality.

Private mortgage insurance (PMI) is one of those options.  In most cases, though, it is an option that borrowers would prefer to avoid.  PMI is a policy established in order to protect the interests of the lending agency in the event that the borrower is unable to fulfill his or her mortgage requirements and defaults on the loan.

Since borrowers want to protect their own interests, PMI is a cost that they would rather not pay.  Here is an overview of how PMI works and how its costs are assessed:

• PMI requirements are based strictly on the appraised value of the home that you intend to purchase with proceeds from a mortgage loan.

• The cost of PMI is generally equal to 0.5 percent of the total value of your loan.  Therefore, the cost can be calculated by multiplying the total value of your mortgage by 0.005.  Then that amount should be divided by 12 in order to determine the extra amount that you will be required to pay each month in addition to your mortgage payment.

• Lenders determine the length of time that a borrower will be required to pay for PMI, but in most cases it will be until 20% of the mortgage loan principle has been satisfied.  This 20% includes the amount of your down payment.  Therefore, if you pay 15% of the loan amount as a down payment, you will be required to pay for PMI until an additional five percent of the principal has been paid.  If you make a ten percent down payment, you will be required to carry the insurance until you have reduced the remaining principal by an additional ten percent.

• Some lenders require that borrowers have PMI coverage until 50% of the principal has been paid.

Naturally, there are exceptions to every rule.  Borrowers who have less than perfect credit may be required to carry PMI longer than other borrowers even, if they have satisfied 50% of the loan principal.

Some mortgage programs, such as FHA (Federal Housing Authority) guaranteed mortgage loans, may require PMI coverage for the entire loan repayment period.

Laws require lenders to engage in certain practices regarding PMI. For standard borrowers with traditional mortgage loans, the lender may not collect PMI payments from the borrower once the loan principal has been reduced by 20%.

To understand your lender’s policy on PMI, and to determine how that policy affects your loan, request a complete up-front disclosure of borrowers’ PMI obligations.

There are alternatives to PMI
Second Mortgage Loans
Because many borrowers avoid mortgages with PMI requirements, lenders have begun to offer programs termed “piggy-back second mortgages.”

These second mortgage loans are issued at the same time as the borrower’s primary mortgage loan and come into effect when the sale is closed.

Generally, a piggy-back loan does not cover the entire 20% down payment, and the borrower must make some sort of payment at the time of closing.  However, when the borrower cannot afford to make a substantial up-front payment (as is often the case when the sale price is several hundred thousand dollars), a second mortgage can assist the borrower in satisfying the primary mortgage requirement while avoiding PMI altogether.

This type of loan is known as an 80-10-10 loan because the primary mortgage covers 80%, the second mortgage covers ten percent, and the borrower covers the final ten percent in the form of a down payment.

The difference in savings between the two options are usually minor, but by making a best-effort guess and talking to your lender to obtain payment amounts, you can save a few dollars each month.

Increased Interest Rate
Believe it or not, many lenders will reduce the length of time that a borrower is required to pay for PMI, or even remove the PMI requirement completely, when the borrower agrees to a higher interest rate. 

It may seem that there is no advantage to accepting an interest rate increase (generally one percent or less). However, you need to recall that interest payments are tax-deductible.  Therefore, if you are in a position to benefit from the additional tax deduction, this may be a good option for you when you are trying to avoid paying for PMI.

Most borrowers choose either to pay for the PMI or to borrow a second mortgage to cover the lender’s down-payment requirement. 

If you find yourself trying to determine which of these options is best for your situation, calculate your monthly mortgage payment with the cost of PMI added in.

Now consider the monthly payment of your primary mortgage with the monthly payment on the second mortgage added in.

In most cases, you will save money each month by opting to borrow the second mortgage loan.  The difference in savings between the two options are usually minor, but by making a best-effort guess and talking to your lender to obtain payment amounts, you can save a few dollars each month.  Over the course of 30 years, these savings can add up.

If you are still confused about your options, the best place to start investigating further is your lender.  The loan officers who work for your mortgage company should have information available for potential borrowers who want to waive the PMI requirement completely.  Also, they should be more than willing to speak to you about obtaining a second mortgage loan.

Your realtor is prepared to help you to wade through the requirements of your particular mortgage loan.  Years of experience taught realtors a trick or two about getting around PMI requirements when buying a new home, and they will be happy to share these tips with you.