A Second Look at Tax Deductible Mortgage Insurance–Beyond the Hype

We’re all aware by now of the recent legislation making mortgage insurance (MI or PMI) tax deductible in 2007. As review, here are the current limitations:

• Applies only to mortgages closed in 2007
• Annual household income cannot exceed $100,000
• Temporary, must be extended to remain in effect for 2008 and beyond
• Must itemize deductions to qualify

But how much is this really going to “help Americans overcome barriers to home ownership” and are we truly “addressing the key issue of housing affordability?” After reading a lot of the early blog posts and announcements, I thought I’d look for some clarity beyond the hype.

First, mortgage insurance (MI) is used with conventional “A Paper” financing or FHA loans. Only about half the borrowers in our market today qualify for those kinds of loans. The reason? Low credit scores, the need for 100% financing, and the fact that many people simply cannot document enough income to qualify for the homes they are buying. Those borrowers are relegated to alternative loan programs that don’t use mortgage insurance.

With falling prices and increasing loan limits, FHA loans could stage a comeback after being all but forgotten over the past 6 or 7 years. And HUD has brought its guidelines into conformity with Fannie Mae & Freddie Mac, removing many of its previous warts. But we still don’t use them here for one big reason. They require fully documented income. I would love to see statistics on the percentage of “stated income” loans to the total, but I know it’s high. And FHA doesn’t do them.

Those who can’t qualify for conventional or government financing use sub prime loans where mortgage insurance isn’t a factor. And in this part of the country, many conventional borrowers earn in excess of the $100,000 threshold. That leaves a pretty small subset of people who will find tax deductible mortgage insurance useful. Even if you do qualify for the deduction, I think you will still find lower overall payments with a 1st/2nd combo.

Example

Let’s look at a $400,000 purchase with 10% down. We’ll leave property taxes and home owners insurance out for this example since they will be the same in either case. At 6%, the principal and interest payment on the 90% 1st loan will be $2158. Add the mortgage insurance (.52 x $360,000 / 12 months) of $156, and the payment is $2314.

Now let’s look at the same price with a 1st / 2nd combo. Principal and interest on the 80% 1st loan is $1919. Payments on the 10% 2nd at 8.5% are $307, for a total of $2226. Savings: still $88 month. I’ve run this example with similar results on 80–15 and an 80–5 as well.

Now since the mortgage insurance costs more than the higher interest 2nd loan, it’s true that you’d have slightly more tax deduction, but the combo 1st and 2nd is still cheaper on an after-tax basis.

So who really benefits from tax deductible mortgage insurance?

• Those who strongly prefer writing a single monthly mortgage check. Believe it or not, I have clients with an insane compulsion to avoid writing two separate checks. If this is your thing, then the new law penalizes you less severely for the convenience of writing one check.
• FHA borrowers. You guys have to have MI, so you win.
• Lower cost areas where incomes and home prices are lower and “full doc” loans more prevalent.
• Best of all in my view is this obscure group. Loan approvals on the piggy back 2nds do not always mirror the approvals on the 1st loans. Sometimes a borrower can meet the approval conditions on a conventional 1st but not on the 2nd, forcing us to seek approval in the sub prime arena where terms are less attractive. In these cases, having the option of doing the 1st loan with mortgage insurance will allow us to offer better loans to those who qualify for the deduction.

I don’t see tax deductible mortgage insurance driving 2nd mortgage interest rates lower as some have speculated. The pool of people who will actually elect MI over a 1st/2nd combo is too small, and the market for home equity loans and lines of credit is too big. Remember the millions of people who set up “stand alone” 2nds after they’ve purchased the home. The capital markets just aren’t that desperate.

And as for all the hyperbole about overcoming barriers and addressing key issues, maybe you’ll find that elsewhere, but not here in California.