As a parting gift to home buyers, one of the final acts of the 2006 Congress was to pass the Tax Relief and Health Care Act of 2006, which covered a wide range of subjects. One small provision may make owning a home less expensive for some folks in 2007.
It's a tax break that allows some homeowners to deduct the cost of private mortgage insurance premiums on their tax returns. This private mortgage insurance is often called PMI. But it doesn't apply to everyone.
When you seek seek long-term home financing, usually the lender wants you to make a down payment of at least 20 percent. That's because studies have shown that buyers who invest less are more likely to default. But having to save up such a large amount of cash is often the biggest hurdle to ownership, especially among younger buyers. As a result, an industry developed in the late 1950s to provide insurance to lenders who wanted to lend more than the traditional 80 percent of purchase price.
A borrower with good credit could obtain private mortgage insurance and then be allowed to borrow up to 90 percent of the home's value. The annual cost for this insurance is typically about half of 1 percent of the loan amount and is typically paid monthly.
So if you wanted to buy a home for $200,000 and minimize your down payment, you might seek PMI insurance so you could borrow 90 percent of the purchase price, a total of $180,000. The PMI premium would be about $900 annually, or about $75 a month.
This program worked well even though the PMI premium has never before been tax deductible. In fact, many PMI insurers offered to insure well-qualified borrowers for up to 95 percent of the purchase price, though the premium was higher.
In the 1990s, banks began offering the extremely flexible home equity line of credit, often called a HELOC. The amount was based on equity in the house and could be paid back in a variety of ways.
Eventually, someone began offering a HELOC of 10 percent to 15 percent of a home's value as a way of avoiding PMI. A buyer could qualify for a purchase loan of 80 percent and a HELOC of 15 percent simultaneously and close both at the settlement table. These combination loans were called piggyback loans and proved extremely popular.
The additional cost of PMI was avoided, and the interest paid on the HELOC was tax deductible. Since most HELOC loans based their interest rate on a floating prime rate, this purchase setup was particularly attractive over the past several years as short-term rates plummeted.
As home values soared, banks became more comfortable offering purchase HELOCs covering as much as 100 percent of a home's value, and the PMI business fell on hard times.
In the summer of 2004, the prime rate stood at 4 percent, making piggyback loans almost irresistible. Why put down your hard-earned cash when you could borrow at 4 percent? But starting in July of that year, the Federal Reserve reversed economic course, and since then the prime has risen steadily and now is above 8 percent.
Now it is cheaper to get a 95 percent acquisition loan and pay the PMI premium than it is to take out a 15 percent HELOC at more than 8 percent, with a possibility of it going even higher.
For years, PMI companies have lobbied for deductibility of their premiums, arguing that they should have equal footing with HELOCs. Congress seems to have granted their wish, at least partially.
Beginning on the first day of this year, home buyers may deduct the full cost of their new PMI premiums. The deduction only helps a taxpayer who itemizes.
The premium is fully deductible for those who have an adjusted gross annual income of less than $100,000. The deduction phases out for those with incomes between $100,000 and $110,000 and is not applicable to those who earn more.
The deduction is not retroactive, so it does not apply to PMI payments on loans originated before this year. Unless extended, this deduction will expire this year on Dec. 31.
If you are a homeowner who refinances this year and gets PMI, you may deduct the premiums for this year, but there are two big catches: You must earn within the income limits and the amount you refinance must not exceed the amount of the original loan (or loans) used to acquire the property. For most current homeowners, this deduction will be no help.
If you are buying today, which alternative is best for you? That's not easy to answer. If you plan to pay off the amount you borrow and it is more than 80 percent in the next few years, a piggyback loan still might be best. It's easy to qualify for, and you can pay it off whenever you want. You still can deduct interest when doing your taxes.
But if I wanted to borrow 95 percent and had no plans to pay more than minimum payments for years, I would carefully consider the PMI alternative. I am guessing the deduction will be extended, and the idea of locking in a lower interest rate for up to 30 years is great.
