New tax deduction created for mortgage insurance

3 min read

Mortgage insurance will be tax-deductible in 2007. For some homeowners, the new law means it will cheaper to get mortgage insurance instead of getting piggyback loans.

The 109th Congress passed the tax law in its final hours. Hundreds of thousands of homeowners will save a total of $91 million when they file their tax returns in 2008, according to estimates prepared by the mortgage insurance industry.

“This is really going to help close to a million Americans who will buy a home next year using mortgage insurance,” says Kevin Schneider, president of U.S. mortgage insurance business for Genworth Financial.

Bottom line for consumers: Don’t get a piggyback loan without taking a serious look at mortgage insurance, because mortgage insurance is likely to be cheaper in the long run, and it might even cost less in the short run.

According to an analysis by Bankrate, a homeowner with a $180,000 mortgage would save about $351 in taxes per year because of the law. That assumes that the borrower has good credit and is in the 25 percent tax bracket.

How mortgage insurance works
When you buy a house, lenders consider you a riskier borrower if you make a down payment of less than 20 percent. There are two main ways to make you pay for that risk: mortgage insurance and piggyback loans.

Mortgage insurance is the old-school method. You, the borrower, pay for the policy, but the lender is the beneficiary. If you fall behind on the loan payments and the lender has to foreclose, the mortgage insurance policy reimburses the lender for legal costs and lost income. The premiums depend on the size of the loan, the percentage of the down payment, your credit score and the type of mortgage insurance you get (private, from a number of companies, or public, from the Federal Housing Administration, Department of Veterans Affairs or Rural Housing Service).

How piggyback loans work
Piggyback loans are the new-wave method of dealing with a down payment of less than 20 percent. When you use a piggyback, you get two home loans: a primary loan for 80 percent of the house’s value and a second mortgage for the rest of the money you need. With a 5 percent down payment, you would get what’s called an 80-15-5 mortgage: an 80 percent loan, a 15 percent piggyback and the 5 percent down payment. Getting a piggyback eliminates the need for mortgage insurance.

The piggyback can be either a fixed-rate home equity loan or a variable-rate home equity line of credit. The piggyback has a higher rate than the first mortgage.

The combined payments on a piggyback mortgage are a bit less than the payment on a single loan with monthly mortgage insurance premiums. For years, piggybacks had a big advantage because the mortgage interest on both loans was tax-deductible, while mortgage insurance payments were not. Now that has changed, with caveats.

Important caveats:
Caveat No. 1: The tax deduction applies only to mortgages that are closed in 2007. If you have a loan with mortgage insurance in 2006, you won’t be able to deduct the premiums in the 2007 tax year unless you refinance in 2007.
Caveat No. 2: There are income limits. You get the full deduction if your adjusted gross income is $100,000 or less. The amount you can deduct phases out rapidly after that, and no mortgage insurance deduction is available if you make more than $110,000.
Caveat No. 3: This is a one-year deal, and Congress would have to renew the deduction to make it apply for the 2008 tax year and beyond. Congress probably will extend the deduction, but you can’t know for sure.
Caveat No. 4: If you take the standard deduction instead of itemizing deductions, the new law makes no difference to you. “You need to have a mortgage of about $130,000 or so to even pay enough interest to hurdle the standard deduction,” says Bob Walters, chief economist for Quicken Loans. In practice, he says, this means that the deduction is available to households with incomes between $50,000 and $100,000.

When you put those complications aside, the new law makes it easier to compare loan offers, says Mike Zimmerman, vice president of investor relations for mortgage insurer MGIC. “Now everything’s on an equal footing: Mortgage insurance is tax-deductible and piggyback is tax-deductible.”

Pay more now or later
Zimmerman says that in many cases, monthly payments on a loan with mortgage insurance will cost more than piggybacks, even after the tax deduction is taken into account. That makes them more expensive in the short run. But private mortgage insurance can be canceled on loans more than two years old if the home’s value has appreciated enough for the owner to have more than 20 percent equity. In contrast, you can’t cancel a piggyback loan. You pay it until it’s paid off.

When deciding between getting a piggyback or mortgage insurance, you have to guess how long you will have the loan. If you think you’ll move or refinance within two or three years, it’s best to go with the option that provides lower monthly payments. But if it’s a fixed-rate loan that you’ll keep for five or more years, it’s probably going to be cheaper in the long run to get mortgage insurance because you can cancel it.

Ask your lender to compare the total costs for piggyback and mortgage-insured loans over the first one, two, five and 10 years, or try out the calculators available on the Web sites of mortgage insurers
PMI Group.