In an earlier article, we presented various options for ensuring that you have positive cash flow when holding rental houses, by minimizing loan payments. One problem which we now can address is to how to eliminate the need for paying mortgage insurance.
Any loan with less than 20% down payment will include or require mortgage insurance. It may be included in the rate (which is called “Lender Paid Mortgage Insurance” or LPMI) or more commonly it is a separate itemized item, but in either case you must pay it.
If you want to pay less than 20% down, the best way to get around mortgage insurance is to finance your purchases with two loans, a first and a second mortgage. For example, the first mortgage is commonly 70%, 75% or 80% of the purchase price and the second mortgage makes up the difference to 90% or 95% of the purchase price. You can get both mortgages from the same lender, but usually you can find better rates on the second mortgage from a lender that specializes in second mortgages. An independent loan broker can put this together for you nicely.
Both mortgages typically close escrow at the same time and both lenders are fully aware of each other. For simplicity, put both loans in the same escrow and sign them both at the same time. If you want to be tricky and try to use two mortgages to get to 100% financing (i.e. no down payment), there are ways to do this, but we do not recommend it and it is not within the scope of this article.
The second mortgage is typically at a higher interest rate than the first, but not always. For example, there are some very competitive home equity lines of credit (HELOCs) with rates only a fraction above the prime interest rate. You have to have good credit scores to qualify, but if you do, they are very attractive. The problem with a HELOC based on the prime rate is that it assumes the prime rate does not get too high before you pay it off. As you may recall from the early 1980s, the prime occasionally does go sky high and it could happen again.
There is a particularly wide variation in the interest rates for second mortgages from various lenders. Moreover, if your credit, income, and assets are not ideal, you may not be qualified for certain second mortgage programs, so it may be more difficult to find a second mortgage at a good rate that you do qualify for. It is very important therefore to ask your independent loan broker to check out various options and to shop the rates. He/she should be comparing at least half a dozen different second mortgage programs.
When you use two loans as described above, it is usually advisable to have an interest-only or minimum payment loan for the first mortgage. This allows you to focus on paying down the principle on second mortgage over a period of say 5 years, if you can afford it. If you cannot do that, than obtain a second mortgage that also has a 5-year fixed period and an interest only option. You are then covered with predictable and low payments for at least 5 years.
This article has reviewed a strategy for improving your cash flow when purchasing investment rental homes — namely, using two loans to eliminate mortgage insurance. There is much more to say on this topic. So keep an eye out for additional articles by the same authors on this and related topics.
(c) Copyright 2004, Jeanette J. Fisher and Robert S. Kramarz. All rights reserved.