August 7, 2000
can�t afford to put 20% down.
My broker says it will cost less to take out a combination first
and second mortgage, where the second would provide another 10% down, than
to put 10% down on a first mortgage and pay mortgage insurance premiums.
He says that even though the rate on the second is high, I�ll
come out ahead because the interest on the second is deductible. Mortgage
insurance premiums are not.
Is he right?�
He is right
about the tax advantage of the combination loan, but coming out ahead
depends on many other factors. These
rate on the second mortgage relative to the rate on the first:
The smaller the difference in rate between the two mortgages, the
greater the advantage of the combination relative to the single
the second mortgage relative to the term on the first:
Shorter term loans pay down the balance faster than longer term
loans. Since the second
mortgage has a higher rate than the first, the faster the second is paid
off relative to the first, the greater the advantage of the combination
compared to the single loan.
bracket: Because the
combination loan enjoys a larger tax write-off, the combination is most
advantageous for borrowers in the highest tax bracket.
costs: With one loan closing, closing costs should be the same for one
loan or two. But if the
second mortgage is from a different lender and requires a separate
closing, the combination will have higher closing costs.
appreciation rate: Borrowers
can request that their mortgage insurance be terminated when the loan
balance reaches 80% of the home�s appreciated value.
This means that the higher the expected appreciation rate, the less
the advantage of the combination.
factors: How long you expect to remain in the home and the rate of
return you can earn on investments also affect how your choices shake
Mortgages Versus One Larger Mortgage, pulls together all
factors affecting the costs of both options on a fixed-rate mortgage.
It also shows the �break-even
rate� on the second mortgage, which is the highest rate it makes sense
to pay. The combination will
save you money if the market rate on the second is below the break-even
borrower purchasing a $200,000 house who plans on remaining there for five
years, and earns 5% on investments.
assumes the borrower is in the highest income tax bracket (39.6%), expects
only 1.25% appreciation on his home, and is shopping the market on July
29, 2000. He compares a
30-year first mortgage for $180,000 (10% down) at 8.25%, zero points, and
mortgage insurance of .52%, with a combination of the same loan for
$160,000 but no mortgage insurance plus a 15-year second mortgage for
$20,000 at 11.75% and zero points. Closing
costs are the same.
Over the 5
years, the breakeven rate for the second mortgage is 20.29% -- well above
the market rate on a second. The
combination is a clear winner.
is the same except that the borrower is assumed to be in the 15% tax
bracket. The breakeven rate
on the second drops to 16.97%, but the combination remains the better
is the same as example 2 but the first mortgage has a 15 year term.
The breakeven rate drops to 11.38%, slightly below the market rate on the second. The borrower
is slightly better off with one mortgage.
is the same as example 3, except that the borrower expects his house to
appreciate at 5% a year, which makes possible early mortgage insurance
breakeven rate drops to 10.10%, which is well below the market rate on the
second. The borrower does
significantly better with one mortgage.
is the same as 4, except that the borrower must pay an additional $1,000
in closing costs on the combination loan.
The breakeven rate drops to 8.68%, which makes the single mortgage
more attractive yet.
general, combination loans are least attractive to low tax bracket
borrowers who take out short-term first mortgages, expect early
termination of mortgage insurance, and face additional closing costs on
Jack Guttentag 2002