- The Washington Times - Wednesday, June 25, 2003

Consumers considering their first home purchase often are overwhelmed by the terminology and technical details involved in getting a mortgage. They have to quickly grasp concepts such as escrow, points, index rate, credit rating, credit scoring, appraised value and the like.

One of the most frustrating concepts of all, however, is private mortgage insurance (PMI). The frustration stems mostly from a lack of understanding.

PMI might seem like another unnecessary expense, but it developed as a way to allow more Americans to buy homes.

Years ago, a 20 percent down payment was absolutely required by lenders. Would-be buyers had to continue paying rent until they could save up a large sum of money to put down on a home of their own. Many found that goal to be out of reach.

“Coming up with a down payment remains the greatest challenge for many families to overcome in buying a home,” said Suzanne C. Hutchinson, executive vice president of the Mortgage Insurance Companies of America (MICA). “Many prospective home buyers may not be aware that they can become homeowners years sooner with a low down payment and private mortgage insurance.”

Lenders desire a 20 percent down payment to protect themselves — and homeowners. The lending industry has found that homeowners with little equity (less than 20 percent) in their homes are more likely to default on their loans. When that happens, the lender eventually will be forced to foreclose. This results in the lender owning the home, which then must be sold — an expensive process and one lenders avoid.

It’s not surprising that so many consumers need PMI or one of the other low down payment alternatives. Homes are expensive around here.

The median price for a house sold in the Washington area was more than $240,000 last year — up 24 percent compared to 2001. A down payment of $48,000 is too steep for most first-time buyers, and many others either cannot afford it or choose to use their savings for investments instead. In 2001, the average down payment among first-time buyers was only 6 percent.

According to MICA, 20 percent to 25 percent of all current mortgages are protected by PMI. The association’s statistics also show that 84 percent of renters who plan to buy a home expect they’ll be unable to scrape together a 20 percent down payment.

Although it is a necessity for these buyers, some find the added cost aggravating, since PMI adds $50 to $150 to the monthly cost of owning the average home.

Here is how the numbers work out: A 10 percent down payment on a $200,000 home results in a loan amount of $180,000. At an interest rate of 5 percent, the principal and interest payment would be $966 each month. PMI on that loan would cost about $100 each month, making the monthly total $1,066, not including property taxes.

The homeowner, however, doesn’t have to pay the $100 PMI for the entire life of the loan. PMI can be canceled upon request, if equity in the home has reached 20 percent of the original value.

Even better, legislation passed in 1998 now forces PMI companies to cancel their policies automatically. PMI will automatically be canceled on all loans originated after July 29, 1999, once the equity in the home exceeds 22 percent.

The lender will be able to tell the borrower exactly when that will happen, based upon the payment schedule.

Although PMI has helped millions of Americans buy homes, it has several disadvantages.

“One significant downside to PMI is that it isn’t tax-deductible,” said Faron Lamb, a vice president at Riggs Bank. “There was a push in Congress to make PMI tax deductible, but it fell apart, unfortunately.”

Another downside to PMI is that it adds nothing to one’s bottom line, as opposed to a “piggyback loan” — a popular way of helping consumers who don’t have a 20 percent down payment.

“These days, Riggs is doing mostly piggyback loans [instead of PMI] because our customers tend to have good credit, and because rates are so low,” Mr. Lamb said.

Piggyback loans package two loans together, one for the home purchase and another to make up the down-payment gap, to avoid PMI altogether.

The 80-10-10 is a common piggyback arrangement, in which the buyer borrows 80 percent of the home’s value, puts down 10 percent, and takes a second loan for 10 percent of the home’s value. The second loan is at a higher interest rate, currently between 6 percent and 8 percent, depending on credit history.

On that same $200,000 home cited in the PMI example earlier, an 80 percent loan ($160,000) at 5 percent would cost $859 per month, not including taxes. The second loan, for $20,000 at a 6.75 percent interest rate, would cost $130 each month. The total cost would be about $989 per month.

That is $77 less than the PMI example, but the buyer will pay for that second mortgage over the entire 30 years. The PMI is usually canceled much earlier than that.

But for those who don’t plan to stay in the home for 15 or 30 years, or who refinance after a few years, the second mortgage is not a disincentive. Most mortgage holders sell or refinance in about five years, making piggyback programs very popular these days.

“Some folks don’t understand how a second trust works, so they would rather get the PMI,” Mr. Lamb said. “PMI makes the whole process simpler because there is only one loan to deal with. And some borrowers take a long time to pay off that higher-rate second mortgage, so they may be better off with the shorter-term burden of PMI.”

Borrowers with shaky credit histories sometimes take the PMI route because the insurance companies are considered more lenient than lenders. Others simply prefer PMI.

Many borrowers avoid PMI these days, however, because the advantages of the piggyback approach are so significant. Borrowers benefit from a tax deduction for the interest on the second mortgage, plus, they build equity each time they make a payment. Neither is true with PMI.

Besides PMI and the piggyback approach, another alternative is an FHA or VA loan.

The Federal Housing Administration (FHA) and Veterans Affairs (VA) offer their own variety of mortgage insurance for eligible borrowers. While FHA and VA loans are not available to everyone, they have some advantages.

FHA borrowers often make 3 percent down payments — half of the national average. FHA insures the loan, with the buyer paying an up-front fee equal to 1.5 percent of the loan and an additional half-percent of the loan amount every month. (There is no upfront fee on condominium purchases, however.)

VA loans require a 2 percent funding fee up front for a first-time buyer — 3 percent for buyers using their VA eligibility for the second time. But with a VA loan, no down payment is required, and there is no monthly fee like there is with an FHA loan.

Fewer Americans are eligible for VA loans than FHA loans.

Another alternative is a “self-insured” loan, in which the lender protects the investment by charging a higher interest rate.

“The problem with the self-insured approach is that your rate stays the same throughout the loan, and you are paying a higher rate on the entire loan amount,” Mr. Lamb said. “So, many borrowers will find that the piggyback is still a better deal.”

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