Comparing Combos to a Loan With Private Mortgage Insurance (PMI)
Up until President Bush signed into law the Tax Relief and Health Care Act of 2006, mortgage insurance premiums were not tax deductible. As of January 1, 2007, borrowers can now deduct those payments. On the surface, this sounds like good news for first-time home buyers. But is it?
One of the driving forces behind taking out piggyback loans, also called combo loans, was the tax deduction available for paying all that interest versus paying a mortgage insurance premium that was not tax deductible on a single loan. The second benefit is that the total payments on a combo loan are often much lower than a payment with PMI.
How Combo Loans Work
Combo or piggyback loans are financing that combines a first mortgage with a second mortgage (with or without a down payment). The reasons these types of loans are appealing are because many home buyers do not have 20% of the purchase price in cash or do not want to put down 20% to buy a home - and combo loans sidestep the requirement to pay PMI. Common types of combo loans are:
- 5/15/80. This scenario involves putting down 5% and financing a first mortgage of 80% of the purchase price, coupled with a second mortgage comprising 15% of the purchase price.
- 10/10/80. This scenario involves putting down 10%, and financing a first mortgage of 80% of the purchase price, coupled with a second mortgage comprising 10% of the purchase price.
- 80/20. This scenario involves putting down zero and financing a first mortgage of 80% of the purchase price, coupled with a second mortgage comprising 20% of the purchase price.
The interest rates on a second mortgage are higher than those on a first mortgage, but sometimes the total payments are less than those financed on a first mortgage with private mortgage insurance. Moreover, since combo loans reached a peak in 2005, many borrowers are considering other options because of short-term interest rate fluctuations.
Comparing PMI and Combo Loans
Let's compare two borrowers with identical FICO scores of 680. Here is how the numbers work:
Say the Klingon family buys a $500,000 home using 80/20 financing. The first mortgage would be at 6.25% and payable at $2,462.87 per month for principal and interest. The second mortgage would be at 8.5% and payable at $768.91 per month, principal and interest.
Total payments for a combo loan: $3,232
100% With PMI
But the Romulan family buys a $500,000 home using 100% financing with PMI insurance. The first mortgage would be also at 6.25% but payable at $3,079, and PMI insurance adds another $400 to that payment.
Total payments for a first mortgage with PMI: $3,479.
The Romulan family needs to wait two years, and obtain an appraisal to show 20% equity, to get rid of the insurance. But say the Romulans do, and the payment drops to $3,079 without PMI. The Romulans would not pay less than the Klingons until month 63 of the loan.
Features of Income Tax Provision for MMI / PMI
Mortgage Insurance premiums (MMI) are paid on FHA, Rural Housing Loans, and some conventional loans require private mortgage insurance (PMI), both of which are deductible subject to certain provisions:
- The Tax Relief and Health Care Act provision for PMI tax deductions applies to funding after Dec. 31, 2006. This means homeowners can deduct mortgage insurance on loans taken out in 2007. The even better news is the fact that under the Mortgage Forgiveness Debt Relief Act of 2007, the PMI tax deduction was extended through 2010.
- Available to persons filing joint or single returns with less than $100,000 of adjusted gross income (AGI), or $50,000 AGI for married persons filing separately. Most people need to earn at least $50,000 to make itemizing a better break than taking the standard deduction, so this pretty much narrows the qualifications to those earning over $50,000 yet less than $100,000.
- Families earning above $110,000 AGI cannot take a deduction. But for those who earn between $100,000 and $110,000 AGI, the deduction phases out by 10% per $1,000.
- The deduction is available on refinances if the original loan amount does not increase. Bump your loan fees into the loan, and you will probably exceed the original balance and not qualify.
Experts are predicting another renewal of the provision based on the following:
- The mortgage insurance tax deduction ends up benefiting taxpayers.
- The provision is well received by home buyers.
- The ability to deduct mortgage insurance helps more first-time home buyers purchase homes.
At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.