Avoiding PMI with an 80/20 Loan When Buying a House

A few months ago a friend of mine declared that he wanted a new car. I asked him if he had the money for it, and of course he didn't. So what did he do? He went down to the local lot, and fell in love with a vehicle right away. He had "car fever." He just had to have a new car, and of course, he ended up buying the first thing he saw that he liked, rather than being wise, saving up, paying cash, and making sure he could get the best deal.

This "purchasing fever" doesn't happen just with cards, it happens with houses just the same. People want to get a new house, and justify to themselves a bunch of reasons why they should have a house right now, regardless of their financial situation. Generally, the rule of thumb is that one should have at least a 20% down payment in order to avoid having to pay for private mortgage insurance (PMI). PMI is essentially foreclosure insurance that pays the bank if they have to foreclose on your home because you didn't pay and they didn't make enough money off of the sale to break even.

A new trend has been to obtain two different loans, called an "80/20" loan in order to avoid paying PMI, which is usually about 0.5% of the mortgage balance each year. A homeowner with a $200,000 mortgage would have to pay about $1000 in PMI annually. An 80/20 loan is where you put 80% of the balance on one loan, which is your traditional mortgage, and put 20% of their mortgage on another loan, which is a second mortgage.

The advantages of the 80/20 loan is that you can avoid non-tax deductible PMI payments, whereas the second mortgage will be tax deductible. The total payment for the two mortgages is often less than just a first mortgage with PMI.

There are also some disadvantages as well. Since the first mortgage gets the first priority to seize your home should you not pay, the second mortgage is accepting greater risk since they do not have your home as collateral. This means that you will usually end up paying a much higher interest rate than on your first mortgage, often as much as 200 basis points, which equates to a 2% higher loan. You will definitely want to compare the mathematics of both options and see which is best for you.