Now that private mortgage insurance (PMI) is tax-deductible, many borrowers may be considering a single loan instead of a “piggyback” second.
In short, PMI is required for any single conventional home loan over 80% loan-to-value, though it can be avoided if you structure a combo loan, keeping the first mortgage at 80% LTV, and putting the remainder of the balance on a second mortgage.
While you wind up with two loans instead of one, you benefit by avoiding PMI altogether. However, you have to take into consideration the cost and mortgage rate of that second mortgage.
So which method makes better sense for you? Let’s look at some of the pros and cons of each.
Combo Loans Eliminate the Need for Mortgage Insurance
The most obvious benefit of utilizing a mortgage combo is that you can avoid paying mortgage insurance each month.
By breaking the loan amount up into two loans, you can circumvent the mortgage insurance requirement, which in turn can save you hundreds of dollars a month depending on the cost.
A common example would be an 80/10/10, which is expressed as an 80% first mortgage with a 10% second and a 10% down payment or equity stake.
Together, it is 90% combined-loan-to-value (CLTV), but since the first mortgage stays at 80%, PMI is not required.
Combo Loans Often Yield Lower Blended Rates
More often than not, a blended rate can save you money. Imagine one loan with PMI at a rate of 7.5% versus a combo loan at a rate of 6.5% on the first mortgage, and 9% on the second loan.
While a rate of 9% may seem high, often the second mortgage is only ten percent of the purchase price or appraised value, so the blended rate here is actually 6.778%.
The saving grace to second mortgages is that they tend to be small, which means the monthly payments are still quite low comparatively, even if the interest rate isn’t.
That’s considerably cheaper than the 7.5% interest rate you’d get with a single loan, and that’s without even factoring in mortgage insurance. Check out my blended rate calculator to determine if two loans price out better than one.
Combo Loans Allow More Financing Options
Typically, a single loan will only allow you to finance up to 95% loan-to-value, but a combo loan will usually give you the option to finance up to 100% of the purchase price.
Mortgage combos also offer the flexibility to structure your loan in a variety of different ways, such as 65/25, 75/15, 80/10, and so on.
This means you can play around with interest rates to find a blended rate that suits your situation best. You can also put less money down and get a more expensive home without the need for mortgage insurance.
Mortgage Insurance Can Help You Avoid High-Cost Second Mortgages
There are situations where a second mortgage rate can be as high as 12%, which is a pretty nasty interest rate. If you elect to stick to one loan with mortgage insurance, rates will be more reasonable, often not exceeding 6% for average to good credit borrowers.
Along with a lower interest rate, you’ll also avoid fees that come with second mortgages, such as underwriting, doc drawing, origination fee, and anything else a broker or mortgage lender may charge you. And you won’t need to worry about a prepayment penalty or early closure fee that second mortgages often carry.
Mortgage Insurance Streamlines the Loan Process
Sometimes breaking up the mortgage into two separate loans can be a lot more work, especially if the loans are being handled by two different banks.
It’s not unusual for a bank to originate your first mortgage and have the second outsourced to another bank. This can make things difficult if the two banks are not in sync, and can often create twice the amount of work, and subsequent headaches.
Also consider post-closing, when you’ll need to make out two separate checks each month for the first and second mortgage. And if you’re ever late, you may be hit with two mortgage lates instead of just one, which could make future financing extremely difficult.
Mortgage Insurance Is Temporary
While mortgage insurance does increase your mortgage payment each month, it does so only until your mortgage balance reaches 78% of the original purchase price of your home. At this point, PMI is automatically canceled by the lender.
And if your loan-to-value reaches 80%, you can initiate the cancellation yourself even earlier.
So if you decide to finance a single loan at 85%, it may only take a few years to eliminate the need for PMI and lower your monthly housing payment.
Mortgage Insurance Is Tax-Deductible
This is a new benefit that was passed by Congress in December 2006, though it must be voted on again this year to remain valid for subsequent years.
PMI is now fully tax-deductible for borrowers if their adjusted gross household income is $100,000 or less. The amount you can write off is then incrementally lower as your household income rises.
Clearly this can make PMI more attractive, but like all tax write-offs, it’s often better not to pay anything to begin with.
Receiving a share of the money back is great, if you must pay it, but not having to pay it at all is even better.
So Which Option Is Better?
PMI companies highlight the fact that mortgage insurance is predictable, affordable, and cancelable. They also say that second mortgages are often adjustable-rate mortgages and that you’re stuck with the loan until you pay it off.
You can argue for or against PMI and combo loans, but the only way to decide what’s best for you is to do the math. You really need to shop around and crunch the numbers to see which scenario makes more sense for you.
There will be cases when each is more attractive based on a variety of factors including loan amount, down payment, transaction type, credit score, income tax bracket, and much more.
You also need to consider how long you’ll be in the property, and what you plan to do with the home.
Be sure to factor in home prices in your area, and whether they are appreciating or dropping. If prices are on the rise, you may reach that 80% loan-to-value mark quickly and you’ll be free of PMI with only one loan to worry about. If prices drop, you could be stuck with PMI for years to come.
If you don’t like the idea of PMI or a second mortgage, there’s always the Bank of America No Fee Mortgage which promises no mortgage insurance even if your loan exceeds 80% loan-to-value.
Similar loan programs are out there as well, and while they don’t explicitly charge PMI, it is typically passed along to the homeowner via a higher mortgage rate.