Q. We have signed a contract to buy our first house and are in the process of shopping for a loan. The purchase price is $225,000 and we plan to put about 10 percent down. All of the lenders have indicated that we will need private mortgage insurance. Exactly what is this and do we need it? Is it tax-deductible? We believe in insurance and are inclined to get it, but need more information.
A This is not the kind of insurance you really want and, to the extent possible, you should try to avoid it. There is a law that just became effective that--for new home buyers--will provide some measure of protection.
To start with the basics, private mortgage insurance (PMI) should not be confused with homeowners insurance, often called hazard insurance and also required by the lender. The latter protects the homeowner in the event of a problem, such as fire, theft or other damage to the house. PMI, on the other hand, protects the lender against financial loss if the homeowner goes into default on the loan and the house has to be sold at a foreclosure sale. If, for example, your house has a loan of $202,500, but at a foreclosure sale sells for only $195,000, PMI will pay the lender the difference so that the lender will not be out-of-pocket.
Unfortunately, you as the homeowner pay these PMI premiums. If you don't put 20 percent down on your property, you generally have no choice: You must take the insurance, and the premiums are not cheap. If you put 10 percent down on a $200,000 house bought with a 30-year fixed-rate mortgage, you will pay about $75 per month for PMI. If you put only 5 percent down, the PMI premium jumps to $120 per month.
The private mortgage industry makes a strong argument in favor of PMI. According to the Mortgage Insurance Companies of America, "With private mortgage insurance, you can buy a home with a down payment with as little as 3 [percent] to 5 percent instead of the 20 percent down payment lenders traditionally have required." Lenders also have learned that borrowers with less than 20 percent equity in their house are more likely to default on their loans.
Keep in mind that you should not be required to obtain PMI if you make a down payment of at least 20 percent. For those who can't, PMI was once the only way to go. But in recent years, lenders have come up with some creative alternatives.
One such approach is known as the "80-10-10" loan. Under this arrangement, the borrower puts down a minimum of 10 percent cash. The lender then makes two loans: one for 80 percent of the full loan amount, and the other (a second trust) for the remaining 10 percent. Because the first deed of trust (mortgage) is only 80 percent of the purchase price, it is considered a conventional loan and no PMI is required. The second trust carries a higher rate of interest, but is clearly tax-deductible. More important, the borrower can easily pay off the second trust; removing PMI often is difficult.
Some lenders have created a program whereby they pay the mortgage insurance but pass those premiums on to the borrower by way of a higher mortgage interest.
There are two important questions always asked about PMI: How do we stop the insurance, and are the payments deductible for tax purposes?
* Stopping mortgage insurance. For years, consumers have had difficulty ridding themselves of their monthly PMI payments. During recent congressional hearings on PMI, numerous horror stories were told, of people paying PMI for the life of their mortgage and of people negotiating for years to get PMI dropped.
As a result of these hearings, the Homeowners Insurance Protection Act was enacted, effective July 29, 1999. Under this law, private mortgage insurance on most loans originated after that date will automatically terminate once the mortgage has amortized to 78 percent of the original purchase price of the house. Lenders are required to advise their borrowers at closing exactly when the mortgage will reach that 78 percent mark.
However, if your mortgage loan was placed before July 29, you will have to discuss your specific situation with your lender. If the lender refuses to allow you to drop this PMI, you may want to consider refinancing. Keep in mind that even if your loan-to-value ratio is more than 80 percent, but less than 90 percent, the 80-10-10 loan may be worth investigating. Do the numbers and compare the costs associated with a refinance.
* Is PMI deductible for tax purposes? As with many areas of tax law, there is no easy, clear answer. Many lenders will tell you that the premiums are not deductible, since the taxpayer can deduct only interest and real estate tax payments. However, some tax attorneys have begun to conclude that PMI payments are deductible after all. In a recent issue of Tax Notes, tax specialist Paul Housey concluded:
"PMI premium payments made by a borrower to a lender are not paid to acquire the PMI policy because the lender is the beneficiary of the policy. Such premiums also are not paid for specific services rendered. Rather, PMI premiums are paid solely for the 'use or forbearance of money,' the same as the stated rate of interest. Thus, such payments should be characterized as interest for federal income tax purposes."
If you pay PMI premiums, it may be worth declaring these payments as interest deductions when you file your next tax return. After all, as Supreme Court Justice Oliver Wendell Holmes Jr. once said: "When it comes to taxes, which is a creature of Congress, anything that you can do creatively to avoid them is legal."
Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.