SANTA CRUZ (January 6, 2008) - Just as the mortgage industry pulls the rug out from under second mortgages, congress steps in with a tax break to help borrowers out. It’s small but every bit helps and here’s how it works.

In the mortgage business, one thing has remained constant for as long as I can remember and that is that lenders have recognized that loaning more than 80 percent of a home’s value represents a risk that they would rather not take without insurance or charging the borrower a premium.

The risk is very clear to see in today’s real estate environment. Any normal economic cycle has its ups and downs and real estate values are no exception. Most homeowners that had loans totaling no more than 80 percent of their value when home values hit their peaks two years ago still have equity in their homes today. Consequently, they could theoretically sell their homes today without having to kick in cash or beg for a short sale.

The same is true with lenders. They would not be suffering the big losses if they had not extended loans that exceeded 80 percent of a home’s value.

However, the combination of demand from homebuyers who wanted to buy with little or no down payment, often with marginal credit, and the temptation by lenders to generate more loans (and more profits) created a boom that worked amazingly well until real estate values headed south.

To reduce lenders’ risk to an acceptable level the concept of mortgage insurance was created long ago. A lender is willing to loan a borrower more than 80 percent of a home’s value providing the borrower qualifies for and pays the premium for mortgage insurance. If the homeowner defaults and there is a foreclosure, the mortgage insurance company will reimburse the lender for its losses. Do not confuse mortgage insurance with the mortgage life insurance that pays off a mortgage in the event of death of the borrower.

Mortgage insurance premiums can add one half to one full percent to the interest rate of the mortgage. It is usually paid monthly and can amount to an additional $400 or more to the borrower’s monthly payments for a loan of $500,000. Up until this year the Internal Revenue Service would not allow mortgage insurance the same deductibility as mortgage interest on an owner occupied residence. Congress then made an exception and allowed the mortgage insurance premiums to carry the same deductibility as mortgage interest for just one trial year, 2007. Earlier this month Congress passed a bill extending this tax deduction through 2010. Be sure to check with your accountant, there are conditions and income limits.

Prior to 2007, the lack of tax deductibility was one of the reasons that second mortgages became popular. Second mortgages also carried higher interest rates which helped to mitigate the risk that lenders faced when loaning more than 80 percent of a home’s value.

Now that the mortgage industry has been burned so badly by providing second mortgages that allowed homeowners to borrow up to 100 percent of a home’s value, second mortgages are not only much harder to qualify for but also are priced higher than just a few months ago. Expect the popularity of mortgage insurance to increase in 2008.

This column is written every Sunday by Peter Boutell, Certified Mortgage Planner and a principal at Santa Cruz Home Finance. You may reach him at (831) 425-1250 or email him at Peter@SantaCruzHomeFinance.com.