Friday, August 31, 2012

Do I need private mortgage insurance?

Every lender wants security—some form of collateral that can be claimed, and if necessary, liquidated—in the event that the borrower doesn't pay.

Properties tend to be secured by "equity." That's the margin between the loan balance and the value of the underlying property. Consider a $60,000 loan secured by a $100,000 home. There is plenty of equity ($40,000 of it), so the lender has plenty of security. If the monthly payments don't come in, the lender can claim the home in a foreclosure.

When the equity is not so substantial, however, the lender has a problem. Even if the home is taken in foreclosure, its value may not match the money that's owed on the mortgage. And the lender must factor in the added costs of hiring lawyers, owning the home for a while, and then maybe paying a broker's commission to resell it.

Enter the solution: Private Mortgage Insurance, or PMI. Traditionally, when a loan balance exceeds 80 percent of the home's value, the owner has been required to insure his ability to pay. If he didn't pay, the insurer would step in and pay if off for him.

PMI has long been required of homebuyers with less than 20 percent to put down. The rates are determined by a formula like this: Multiply the loan balance by .005. So an $80,000 balance would require annual PMI of $400, which is divided into monthly payments of $33.

Most homebuyers need PMI because 20 percent of the sale price on a home is a big chunk of money. But when the principle balance drops below 80 percent of the home value (perhaps after a few years of payments) lenders are required to notify homeowners and drop the PMI requirement.

With the looser lending standards of the past decade, the lending industry devised ways for borrowers to dodge the PMI requirement. A borrower lacking a 20 percent payment was allowed to take out a "second" loan to make up the difference.

Someone with only a 10 percent down payment, for example, could accept one loan for 80 percent of the purchase price and a second one for 10 percent. The "second" has a higher interest rate because the lender is at greater risk and if the home is foreclosed, his lien is in a junior position to the first lender. And voila! No more PMI. Another advantage to the buyer was that interest paid on the second loan was tax deductible—unlike PMI.
However, financing tricks like that are mostly a thing of the past. At this point, very few lenders have much cash to put into second-position loans on purchases that are already highly leveraged. Another option in the past was to pay more interest on your first-position note. Some lenders were willing to waive the PMI requirement in exchange for interest rates .75 percent to 1 percent higher. Nice terms if you can find them. But if you do, check your calendar—you may be stuck in a 10-year time warp.

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