Which is better: PMI or piggyback loan?

Homeowners who make a down payment of less than 20 percent are usually required to pay private mortgage insurance (PMI), because they are considered to be at higher risk of default. PMI premiums are typically around half a percent of the interest rate, which is about $83 a month on a $200,000 mortgage.

Piggyback loans were created as an alternative to this extra expense. With this strategy, the homeowner makes a 10 percent down payment, gets a mortgage for 80 percent of the home’s value, and then takes out a second loan for the remaining 10 percent. Because no single loan exceeds 80 percent of the property’s value, PMI isn’t required. The combined payment of the two loans may be less than the cost of a single mortgage plus PMI, especially since the interest on a piggyback loan may be tax-deductible.

In recent years, piggyback loans -- which are sometimes structured as home equity lines of credit -- were so attractive that mortgage insurance companies were losing customers in droves. But two important things have happened to even the playing field. First, the prime rate (the rate these loans are most often tied to) has more than doubled since the summer of 2004, while mortgage insurance premiums have stayed about the same. Second, a new federal law allows some taxpayers who buy a home in 2007 to deduct their PMI premiums. These two changes have closed the price gap between the two options.

For example, let’s say you’re purchasing a $250,000 home with a down payment of 10 percent and have opted for a 30-year fixed-rate mortgage at 5.75 percent.

Here’s how your choices might look:

Option 1: You take out a mortgage for 90% of the home’s value ($225,000) and pay PMI.

Mortgage payment: $1,313.04
PMI premium (0.5%): $93.75
Total monthly payment: $1,406.79

Option 2: You take out a mortgage for 80% of the home’s value ($200,000), plus a piggyback loan for the other $25,000.

Mortgage payment: $1,167.15
Piggyback loan payment (8.5%): $192.23
Total monthly payment: $1,359.38

In this case, the monthly payment is almost $48 lower with Option 2, though the piggyback loan may carry origination fees that add to the cost of this option. In addition, if you are able to claim your PMI premiums, you may be able to get a larger tax deduction with Option 1. A small change in any of the interest rates used in this example can also tip the balance in the other direction.

A few caveats about the new law, which companies selling PMI have long lobbied for. It allows taxpayers to deduct PMI premiums as long as their adjusted gross income is $100,000 or less. It applies only to people who purchase a home in 2007. It is unclear whether or not the law will be extended into 2008 and beyond. If you’re already paying premiums on an existing mortgage, you can’t claim the deduction.

If you’re planning to buy a home with a down payment of less than 20 percent in 2007, talk to an accountant or tax adviser who can help you determine which option is the least expensive in your particular situation.

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