The concept of mortgage insurance helped bring a lower down-payment to mortgage lending and helped bolster home ownership during our generation.
The purpose of mortgage insurance is clear. It allows a conventional lender to offer a lower down-payment mortgage without taking too much risk. The borrower pays for insurance which covers part of the loan against default.* The amount of “coverage” required is determined by the “agencies” (Fannie Mae and Freddie Mac), other secondary market entities or lenders themselves.
Two Alternatives – Sales Price: $400,000
Loan Amount: $360,000
Rate: 5.0%
Mortgage Insurance .67%
Combo Alternative – $320,000 First Mortgage — $40,000 Second at 8.0%
Note that these rates are for illustration purposes only–they do not reflect actual interest and mortgage insurance rates.
One option to alleviate the need for mortgage insurance in some cases is the use of a “combo” mortgage. The concept of a combo is simple–instead of paying extra on the entire mortgage, use a second mortgage to keep the first mortgage at 80% of the sales price. For example, instead of a ten percent down-payment and a loan that is 90% of the amount of the sales price (Loan-to-value or LTV)–the purchaser opts for a–
80.0% first mortgage
10.0% second mortgage
10.0% down
This “combo” is known as an “80-10-10”
Some mortgage companies will tell you that a combo alternative is better because it eliminates the need for mortgage insurance. This assessment does not make sense. There are times in which a combo makes sense and there are times in which having mortgage insurance makes sense.
•The advantage of a combo is two-fold–The interest on a second mortgage may be tax deductible while mortgage insurance may not be in all instances.
•While the rate on the second mortgage is higher than the rate on the first, the higher rate is paid only on the amount of the second, not on the entire mortgage which is the case of mortgage insurance.
In other words, the “blended rate” of the combo may well be less than that of the mortgage with mortgage insurance–especially after taxes are figured into the equation.
Why is the elimination of mortgage insurance not always a good idea? Mortgage insurance can be cancelled after a certain period of time. The typical second mortgage payment will last for a minimum of 15 years without refinancing. The Homeowners Protection Act of 1998 states that mortgage insurance must be cancelled after the loan balance reaches 78% of the original sales price based upon scheduled amortization. However, if the home goes up in value, the insurance can be cancelled within two years if the loan balance reaches 75% of the new value. Cancellation can occur within five years if the loan balance reaches 80% of the new value.
What if the purchaser remodels the home? What if the purchaser bought the home at a below-market price? They may save money for two years–but then wind up paying a higher amount for the rest of the term of the mortgage!
A trained loan officer will spend time finding out more about the transaction before they recommend either option. Beware of saving money in the short-run while paying thousands more in the long-run.
*It should be noted that there is an alternative which is typically called lender-paid mortgage insurance. In this case the lender would pay the mortgage insurance while the borrower pays a higher rate that can become tax deductible.
