By sbup Staff
Historically, lenders have required a 20% down payment in order to qualify for a primary mortgage. The 20% down payment is meant to protect lenders from losing money if the property depreciates or the borrower defaults and the lender is forced to sell the property for less than the loan amount.
If a homebuyer is unable to provide a 20% down payment, it’s still possible to obtain a mortgage. In these cases, the homebuyer will typically have to pay for private mortgage insurance (PMI), however. PMI covers a lender’s losses if a borrower defaults. In effect, it serves the same purpose as a buyer’s down payment.
The cost of PMI depends on the size of the loan and the size of the down payment. Typically, it amounts to about 0.05% of the loan amount, according to the Mortgage Bankers Association of America. For example, if you only put down $20,000 (or 10%) on a $200,000 property, you could expect to pay annual PMI premium of about $901 ($180,000 loan amount x 0.005). That would be monthly payments of about $75. These payments are not tax deductible. Some lenders will, however, waive the PMI requirement in exchange for a higher interest rate. In this case the interest is tax deductible.
When the homebuyer accrues 80% equity in the home, most lenders will drop the PMI requirement. A lender is required to notify you at closing how long it will take to acquire 20% equity through principal payments. Many homeowners move out of their home before this happens, however.
There is a way to avoid paying PMI. So-called “piggyback loans” use two loans to solve the 20% down payment problem. The primary mortgage is financed for 80% of the sales price and a second mortgage is used to make up the difference between the down payment and the remainder of the sales price. For example, for an “80-10-10” loan on a $200,000, the primary mortgage would be for $160,000, the second mortgage would be for $20,000 and the homebuyer would have to provide a $20,000 down payment. In this scenario, no PMI would have to be paid because the primary mortgage is only for 80% of the sales price.
In a piggyback loan, the second mortgage will carry a higher interest rate, but it is usually a better deal than paying PMI. Using the same example, assume the primary mortgage has an interest rate of 5.5% and the second mortgage has an interest rate of 7.5%. The first mortgage payment would be for about $908, and the second mortgage payment would be for about $140. That’s a total of $1048. If you paid PMI instead of taking out a second mortgage, your monthly payment would be $1022 plus $75 PMI for a total of $1097. That’s an extra $49. Plus, with a piggyback loan, the mortgage interest is tax deductible.
In the current lending environment, both private mortgage insurance and second mortgages are difficult to obtain. Some PMI underwriters are hesitant to write policies because of falling home prices. Claims from lenders are rising due to increases in foreclosures and more homeowners being “underwater” in their mortgages. The second mortgage industry has also tightened significantly for the same reasons. If a home goes into foreclosure, a second mortgage is often never recovered. For the moment, only the best-qualified borrowers are able to get a mortgage with less than 20% down payment.