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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2007

PMI Vs. Piggybacks: Who’s Got Your Back?

Determine whether a loan with private mortgage insurance or a piggyback loan is more suitable for your clients

r_2007-08_Groover_spotWith recent changes to the tax-deductibility of private mortgage insurance (PMI), the question arises: “What is the most cost-effective method of financing high loan-to-value (LTV) residential real estate transactions?”

Should your clients structure their transactions using a piggyback loan — i.e., an 80-percent-LTV first loan with a 10-percent-LTV second loan and 10-percent down payment — or a 90-percent-LTV first loan with a 10-percent down payment and PMI?

Unfortunately, there is not one correct answer. It depends on your clients and their needs.

Because piggyback loans have been so common in recent years, some brokers might need a refresher on PMI. PMI is an insurance policy that borrowers pay and that protects the lender should borrowers stop making mortgage payments.

When you understand what PMI entails, as well as the differences between a loan with PMI and a piggyback loan, you can better help your clients choose the best option for them.

How does PMI work?

Historically, borrowers with less than a 20-percent down payment have been more likely to default on their loans than borrowers who make down payments of 20 percent or more. PMI is specifically designed to address that default risk.

PMI does not insure the entire loan; rather, it typically covers only 20 percent to 30 percent. This is because most lenders feel that the real estate used to secure the loan will cover the remaining 70 percent to 80 percent of a loan, should a default occur that requires the property to be sold.

As an example, let’s assume that we have a 90-percent-LTV borrower with one loan against a single-family residence. The lender might assume that in a bad real estate market, it can recover 75 percent of the loan amount by foreclosure and sale of the property, which would leave it with a 25-percent exposure to potential loss. But if the PMI on the loan covers the lender for 30 percent of the loan amount, then it covers that 25-percent loss to the lender.

With PMI, therefore, lenders can take more risks and lend to borrowers who don’t have down payments greater than 20 percent. In addition, PMI is available for home purchases and refinances, so buyers with small down payments benefit from the availability of PMI, as do owners who wish to refinance with little equity.

In addition, your borrowers don’t have to worry about the PMI-application process. The broker or lender arranges the PMI policy. Although borrowers don’t play a key role in selecting their PMI policy, ask if they have any special payment preferences. The PMI industry has a wide range of payment options that will suit most borrowers’ needs.

Borrowers can choose to pay their PMI premiums in monthly installments or in one upfront payment. If they choose to make one upfront payment, they can do so in cash or as part of the loan.

Additionally, some companies offer an option of “cashless” payment of the PMI premiums, aka lender-paid mortgage insurance. Although the payment is cashless, however, it is not free. The cost of the PMI premiums is reflected in higher interest rates for the loan.

One benefit this year is that PMI premiums are tax-deductible for many borrowers who purchase or refinance their homes in 2007. Advise your clients to consult their tax advisers to determine if they are eligible to deduct PMI premiums this year.

The cancellation factor

For many borrowers, PMI can be canceled within a few years. By federal law, PMI on most loans originated on or after July 29, 1999, should terminate automatically when the outstanding loan balance reaches 78percent of the value of the real estate being insured.

There are two ways that a property’s LTV decreases:

  1. Its market value increases while the outstanding loan balance decreases, remains the same or increases slower than the relative increase of the market value.
  2. The outstanding loan balance decreases while the property’s market value increases, remains the same or decreases slower than the relative decrease in the outstanding loan balance.

If either situation occurs, borrowers should explore canceling their PMI. They can do so by contacting their loan servicer (which also may be the lender) and indicating they would like to cancel their PMI. The loan servicer will probably request information regarding the loan terms, as well as additional information about the home’s value, including an appraisal, a comparative market analysis or both. The servicer also often will prefer the cancellation in writing.

Once PMI is canceled, borrowers who paid the monthly premiums simply stop making those payments. Borrowers who paid the PMI premium as a single upfront payment may be able to recover the unused portion of the premium paid.

PMI vs. piggybacks

This brings us back to the issue of which is better for a borrower: a larger first mortgage with PMI or a piggyback loan that comprises a smaller first loan, a second mortgage and a down payment. Each option has certain factors that should be considered.

When considering a second mortgage, keep in mind that:

  • Interest on the second mortgage is tax-deductible for most borrowers.
  • Borrowers may be able to qualify for a second mortgage but not for PMI.

It might help to compare costs. Imagine that you have borrowers who want to purchase a $220,300 home with a 10-percent down payment ($22,030). The borrowers pay all closing costs and want to minimize monthly payments.

In a piggyback scenario, your borrowers’ 80-percent first mortgage would be $176,240, and their 10-percent second mortgage would equal $22,030. Here, the first mortgage would be a 30-year loan with a 6-percent interest rate; the second mortgage would have 15-year amortization with a 9-percent interest rate.

On the other hand, looking at a 90-percent first loan with PMI, the first mortgage would total $198,270. The single-premium PMI would be financed into the loan and would equal $3,469.73. Therefore, the new mortgage amount would be $201,739.73. Assume that this loan has a 6.25 percent interest rate with 30-year amortization.

With these factors in mind, the monthly costs for financing the property with a piggyback loan would be $1,280.09 (based on a first-mortgage monthly payment of $1,056.65 and a second-mortgage monthly payment of $223.44).

In the PMI scenario, on the other hand, the monthly costs for financing the property with a first mortgage and PMI would be $1,242.15.

Even with a higher interest rate on the first mortgage, the PMI scenario has a somewhat lower monthly cost than the piggyback scenario. As such, borrowers whose primary interest is to minimize their monthly payments would be inclined to use a 90-percent-LTV first loan and PMI, rather than an 80/10/10 piggyback loan, given these two loan scenarios.

PMI isn’t right for every borrower, but it can help those with high-LTV scenarios purchase or refinance property that they might not afford with a piggyback loan. PMI can be the difference between a transaction closing or not — and the difference between you getting paid or not.


 


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