Earlier this month, the 109th Congress passed a bill allowing many American homeowners to write private and government mortgage insurance off of their income taxes starting in 2007.  The new deduction helps reduce the barriers to home-ownership for many first-time and/or low-income homebuyers….making this new deduction a special gift to young Americans!

What does all this mean?  When purchasing a home with a down payment of less than 20%, virtually all lenders in the US require private mortgage insurance (PMI).  PMI is a premium paid in addition to the regular principal and interest payments on your mortgage.  If your home appreciates in value or you pay down the mortgage so that you have at least 20% in equity, you can contact your lender to have the PMI premium cancelled. 

In the past, PMI was a cost of financing that you could not write off of your income taxes, so many home-buyers sought out a variety of methods to avoid paying private mortgage insurance.  However, there are significant drawbacks to all of the methods. 

One popular method is to take a “piggyback loan”.  With a piggyback loan, you open two mortgages: a conventional first mortgage for 80% of the purchase price of your new home, and a second mortgage for 5-20% of the price depending on the amount of your down payment.  Since the first mortgage does not exceed 80% loan-to-value, PMI is not required, and PMI is rarely, if ever, required for a second mortgage.   

The major drawback to a piggyback scenario is that the interest rate and terms on the second mortgage are often not favorable to the borrower.  In many cases, the rate can approach or exceed 10% and the loan be structured around a “balloon payment”, where after a set period of time (usually 10-15 years) the entire balance of the loan is due and payable.  If the borrower is unable to refinance at that point, he or she may face losing the home! 

Another method has been to open a single mortgage loan in which the lender pays PMI premiums on the behalf of the borrower in return for a slightly higher interest rate.  This option avoids a high-rate second mortgage, and since the borrower is actually paying a higher interest rate instead of the PMI premium (which is paid by the lender), the borrower can write off the additional cost as mortgage interest. 

This method also suffers from a major drawback, in that the higher interest rate is effective for the entire term of the loan.  With traditional PMI, the lender must cancel the mortgage insurance once the borrower has 20% equity in the home.  In an appreciating housing market, building that equity may take as little time as a year or two.  By having the lender pay PMI on your behalf for the life of the loan, you potentially suffer a higher interest rate for the entire 30 year term of your mortgage - thousands of dollars lost if you do not or are unable to refinance once you have 20% equity.

However, with the passage of the new tax deduction, any borrower with annual household income of less than $100,000 will be able to deduct the cost of private mortgage insurance from their taxes starting in 2007.  This new deduction is a significant step towards making home ownership a reality for millions of low-income Americans.  As quoted by the Mortgage Insurance Companies of America, Marc Morial of the National Urban League said:

“A tax deduction for mortgage insurance premiums will go a long way to help homeowners and potential homeowners who simply want to own a piece of the American Dream.  I congratulate both the U.S. House and the Senate for doing what’s right to make the goal of affordable homeownership a reality for every American.”

Buying a home is truly one of the most important steps on the path towards lasting wealth.  Quarterlife Finance will discuss how a young American can go about purchasing real estate in detail as we progress with our Plan for financial success.