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How mortgage insurance beats the piggyback trap

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For many homebuyers, the biggest hurdle in the home buying process is saving for the down payment. Amassing a large amount of cash - usually 20 percent of the property value - can be difficult and discouraging, especially in today's high-priced real estate markets.

Private mortgage insurance, an often misunderstood product, enables homebuyers who lack that 20 percent or more down payment to achieve their dream of homeownership - without having to take on a second mortgage with its potential risks.

Record low rates: The end is in sight

Dramatic declines in mortgage rates over the last four years triggered a boom in mortgage lending. The Mortgage Bankers Association reported that approximately $2.8 trillion of mortgages were originated in 2004, almost triple the 2000 levels. Mortgage rates in 2004 averaged 5.84 percent, the second lowest annual rate recorded since tracking began in the late 1970s.

One consequence of the low interest rate cycle has been that some borrowers unable to put down 20 percent have utilized a product structure known as a "piggyback" loan instead of mortgage insurance.

Typically a piggyback loan layers an adjustable-rate second mortgage on top of a first mortgage to make up for the lower down payment. These structures are also called 80-10-10s, denoting an 80 percent first mortgage, 10 percent second mortgage, and 10 percent down payment, but there are many different variants among piggyback structures.

Borrowers have also turned to interest-only loans, which allow them to make "interest-only" payments during a defined period, usually five to 10 years.

At the end of that period, the payment is raised to the fully amortizing level over the remaining term of the loan - potentially providing quite a payment shock.

For example, monthly payments on a $200,000 interest-only 5/1 adjustable rate mortgage (ARM) would jump from $833 to $1,169* after five years - even if the interest rate stayed the same.

These kinds of new financing vehicles may have seemed attractive when interest rates were low, but that era may be over. The prime rate has increased seven consecutive times since June 30, 2004, and the cost of borrowing would likely keep rising if the Fed continues measures to restrain inflationary pressures.

Indications are that piggyback customers with adjustable-rate second mortgages could be dangerously exposed as rates rise. As a result, borrowers could face considerably larger monthly payments.

In addition, if property appreciation rates decline, borrowers who need to sell their properties may not be able to get the price they're counting on, which may lead to an increase in defaults. In a rising interest rate environment, mortgage insurance can mitigate the additional risk that these financing options may pose.

Private mortgage insurance makes sense

By obtaining a loan with private mortgage insurance, borrowers can have just one loan and lock in the lowest possible fixed interest rate. Unlike most second mortgages, the cost of mortgage insurance is fixed and not subject to volatile interest rate fluctuations, so borrowers know what their payments will be.

Another advantage is that mortgage insurance is cancelable under federal law. Homebuyers with mortgage insurance build equity in their homes at a faster pace than borrowers using a piggyback structure. So when their homes appreciate, homeowners build greater equity and consequently can cancel mortgage insurance sooner - resulting in greater savings.

Everyone's financial situation is different, but it's important to recognize that the smartest decisions are the ones that work out best in the long run. These historically low interest rates won't last forever - and what could look like a cheaper option today could be more expensive for homebuyers in the long run.

In today's interest rate environment, for high-ration borrowers, mortgage insurance is a more sensible and predictable way to finance a home than a piggyback loan.

* $200,000, 5 percent initial rate, 30-year term, five-year interest-only period, fully amortizing period equals 25 years

Katkov is an executive vice president of sales, field operations and product development for PMI Mortgage Insurance Co., based in Walnut Creek, Calif.

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