SANTA CRUZ (June 15, 2008) -When I started originating loans over 20 years ago, sellers were leery of an offer to buy their home that depended on a loan that allowed a down payment of just 5 percent. A loan with this low of a down payment down was rare and was not trusted as being dependable by sellers and their agents. How times have changed!

In the 1980s there were basically two ways to buy a home with less than 20 percent down. One was with the assistance of seller financing. A transaction in  which the seller provided a second mortgage for 10 percent of the sales price and the first mortgage was for 80 percent of the sales price required the buyer to come up with enough cash to cover the 10 percent down payment plus closing costs was popularly referred to as an ‘80-10-10’ purchase. Or, with just 5 percent down and a 15 percent seller second would be called a ‘80-15-5’.

If the seller was unwilling or unable to provide a second mortgage, buyers had to seek and get approval for mortgage insurance. To this day, lenders are not interested in lending more than 80 percent of a property’s value without mortgage insurance, which is an insurance policy that is paid for by the buyer but protects the lender in case there is a loss incurred if the buyer fails to make payments as promised.

Mortgage insurance was often a hassle to deal with. It was expensive for the buyer, it was not deductible for IRS purposes, it required another, stricter level of approval and it was hard to get rid of without refinancing.

The mortgage industry came up with an alternative to mortgage insurance and it proved to be second mortgages from conventional lenders. The rates were higher but since the loan amounts were relatively small when compared to the first mortgage, the impact on the monthly mortgage payment was, generally, acceptable. Additionally, interest on second mortgages is deductible, just like the interest on first mortgages. Keep in mind that mortgage interest is deductible as long as it represents acquisition indebtedness (of a primary residence or second home) and the mortgage is less than $1,000,000. In addition, the IRS allows interest deduction on a mortgage up to another $100,000.

Today, however, second mortgages that used to allow a homebuyer to borrow up to 90 or 95 percent of the sales price have become a victim of the mortgage meltdown and over the past several months have become almost extinct.

Mortgage insurance is again back in vogue and will allow a homebuyer to borrow up to 95 percent of the value of a home and, as I mentioned in a column earlier this year, mortgage insurance is now tax deductible, with exceptions. However, it is expensive and will cost nearly one full percent of the loan amount for a 95 percent loan. That means that if the 30 year fixed rate was at 6 percent, with mortgage insurance it would cost the homebuyer nearly 7 percent to borrow money. The good news is that the mortgage insurance premium does not last forever and will be cancelled by the lender when certain requirements are met.

Alternatively, some lenders offer to pay for the mortgage insurance via a permanent increase in interest rate. This is referred to as ‘self-insurance’. For example, a 95 percent loan would cost the homebuyer an additional one half percent in rate. The disadvantage is, of course, that this will be the permanent rate for the entire term of the loan.

FHA requires mortgage insurance on all loans, regardless of the loan-to-value ratio. There is an upfront premium due of 1.5 percent of the loan amount, which can be financed by increasing the loan amount. Additionally, there is a monthly premium to pay equal to one half of one percent of the loan amount, divided by 12. FHA will not consider dropping the monthly premium for the first five years and then will only do so when the loan-to-value ratio drops below 78 percent. The value used for this calculation is the original sales price of the home.

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 of email him at Peter@SantaCruzHomeFinance.com.