Piggyback or PMI?

From the Wall Street Journal:

When It Makes Sense to Pay PMI

My sister Melissa and her husband Joe have finally pulled the trigger and made an offer to buy a house, after years of struggling to find something affordable near my Jersey Shore town.

Melissa and Joe have enough in savings to make a 10% down payment on the $250,000 home, but doing so would leave them with no financial cushion. Instead, they want to put just 5% down and save the rest for financial emergencies and to pay other expenses, such as moving costs and making minor improvements to their new home.

So the couple is considering two options. One would be to take out a traditional 30-year fixed-rate mortgage for 95% of the cost of the home and pay the remaining 5% out of their savings. Because they’d be financing more than 80% of the home price, they’d be required to pay private mortgage insurance (PMI) — coverage that protects a lender in the event the homeowner defaults on the loan.

Piggyback mortgages grew in popularity when mortgage and interest rates were low. (Mortgage rates track the movements of the Treasury market, while second mortgages — or home-equity loans — move in line with the Federal Reserve’s fed-funds target rate.)

But after the Fed began incrementally raising short-term rates — to 5.25% today from 1.25% in June 2004 — piggyback loans began to lose their luster. The problem? The second mortgage payment became too expensive for some borrowers, says Keith Gumbinger, spokesman for New Jersey mortgage-data publisher HSH Associates.

This year homebuyers such as Melissa and Joe have another reason to avoid non-traditional loans such as piggybacks. 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.

So does it make sense for my sister to pay PMI? I asked Mr. Gumbinger of HSH to run 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 second loan, 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 fixed-rate 30-year 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. So Melissa and Joe would save just $30 a month for the remainder of this year by going with the piggyback loan.

The iffy housing market also may mean Melissa and Joe’s home will appreciate in value much more slowly than in recent years, or may even decline, forcing them 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.

While traditional loans are looking more appealing these days, there’s also no guarantee that PMI premiums will remain tax-deductible — the law is set to expire in 2008. Melissa and Joe are likely to begin making mortgage payments in August, so the tax benefits would be relatively small. (And if they took the standard deduction when they filed, rather than itemizing, they wouldn’t be able to deduct PMI premiums at all.)

In the end, Melissa and Joe decided to go with the piggyback loan, largely due to the flexibility of the lower monthly payment and their doubts that the tax break for PMI will be extended for purchases and refinancings after 2007. Because the short-term second loan pays down principal more quickly than a long-term first mortgage would, they’ll save on interest by making additional principal payments to pay down the second mortgage. Since they’ll likely receive a much larger refund thanks to mortgage-interest and property-tax deductions, they plan on reducing their tax withholding so there’s more income to make those payments. (This IRS withholding calculator can help you determine how much to withhold.)

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4 Responses to Piggyback or PMI?

  1. Pat says:

    Forget calculating the cost savings and predicting the future of the PMI deduction….I want the low-down on the shore town with houses for $250, Terri.

    Are they within walking distance to beach access and/or a Dunkin Donuts?

  2. Heebner: “Home Prices Decline at Least 20%”

    The always colorful Ken Heebner, portfolio manager for the Boston-based CGM Realty Fund, talks at length about his outlook for the nations housing markets. Heebner see the greatest home price decline since the Great Depression coming with at least a 20% decline.

    Originally aired on: 4/13/2007 on Bloomberg

    Running Time: 12 minutes 1 seconds

    http://www.paperdinero.com/BNN.aspx?id=144

  3. R Patrick says:

    Also second motgage normally a heloc

    at least wiht the big first mortage you pay 100 more now but you know what you are paying for 20-40 years. No surprises

  4. BuyNextYear says:

    Should this couple really be buying? My advice is to save at least 20% for the downpayment and enough to cover other expenses. Otherwise keep renting and stay away from buying.

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