First, let’s start with the basics: what is PMI? As implied by the name, PMI is literally an insurance policy on your mortgage, which protects the lender in case of default. Typically, PMI is required on mortgages with a loan-to-value of greater than 80% (i.e. when the down-payment is less than 20% of the value of the mortgage). The insurance is calculated as a percentage of the the total mortgage value, and is rolled into the monthly mortgage payment.

PMI is not cheap, and will average about $1,000 per year on a $200,000 mortgage. Generally speaking, insurance premiums for fixed-rate mortgages are lower than for variable-rate mortgages. In addition, long mortgage durations (30 years, as opposed to 15 years), and high loan-to-value mortgages are associated with higher PMI premiums. This is to be expected, since mortgages with these characteristics typically have higher default rates.

One alternative to making monthly PMI payments is to roll a one-time premium into the mortgage. Thanks to current tax rules (mortgage interest is tax-deductible, while PMI premiums are not), it will be cost-effective for the average borrower to do so. Unfortunately, most borrowers are not aware of this possibility, because lenders require special authorization to process it and hence avoid mentioning it to prospective borrowers. Finally, while such a strategy will technically raise the size of your mortgage, some (or even most) of this premium will be rebated to you when it is determined that you no longer need it.

Speaking of which, mortgage insurance is only a temporary outlay. After your loan-to-value ratio exceeds 80%, you will no longer be required to pay for it. This is natural, since if your loan-to-value ratio had been this high when you first obtained the mortgage, you wouldn’t have been required to purchase PMI.  In fact, thanks to a law passed in 1999, lenders must take the initiative to cancel the mortgage insurance agreement when the LTV falls below 78%, based on the initial appraised value of the home. Borrowers are also entitled to early cancellation (though, you must request it), if your equity exceeds 25%, based on a current appraisal of the home.

As I mentioned, private mortgage insurance is quite expensive, and hence not-at-all desirable. This is because the mortgage insurer is selected by the lender – not by the borrower – which doesn’t have as much of an incentive to cut costs. Accordingly, it might be economical to pay a higher interest rate in lieu of PMI, if your lender offers you such an option. The best approach is to simply (save up until you can afford to) make a higher down-payment, such that PMI is no longer necessary.

Towards that end, Fannie will effectively guarantee all-short term debt issued by such lending institutions, provided that funds received from such debt issuance is used to originate new mortgages that meet Fannie’s lending standards. It should be noted that in most cases, Fannie Mae (and/or its counterpart, Freddie Mac) already guarantee the majority of the mortgages issued by such lenders. While this protects the mortgages that the lenders originate, it doesn’t protect the lenders themselves. Thus, this program, will make it easier for small lenders to raise capital to fund mortgage-origination activities by guaranteeing their solvency.

The upshot is that this should not only increase overall mortgage lending activity, but also enable smaller lenders to compete more effectively more with the big boys. Previously, small lenders were hoarding existing capital and having trouble raising new capital, since investors were rightfully worried about the viability of the loans that they were making. For better or worse, this initiative means that they should be able to offer new mortgages at lower rates and less rigid lending standards.

Certainly, this program is not without its critics. The WSJ has suggested tongue-in-cheek that the government should just go ahead and nationalize the entire mortgage lending industry given that it is now directly responsible for ensuring its functioning. “Fannie and Freddie’s guarantees and subsidies helped to create the housing disaster, which has led the Fed directly to purchase mortgage-backed securities and mess up the market for small mortgage lenders, which in turn is leading Fan and Fred to guarantee the debt of those small lenders,” summarized its editorial board.

For those of you contemplating a mortgage, this means that you can obtain one from a small lender, without worrying about whether it will still be in business tomorrow. There’s no longer a substantial advantage associated with taking out a mortgage from a “Big-Box” lender, since smaller lenders can now compete on terms and pricing. In fact, given the bureaucracy of large lenders, it might be smoother to simply work with a regional/community lender, with which it will be easier to work with in the event of a problem.

While it’s impossible to offer a comprehensive explanation for this divergence, most analysts attribute it to the fact that the different mortgages are being utilized by different types of borrowers. “The main users of 15-year loans…are established homeowners refinancing mortgages — people secure enough that they often take on larger monthly payments in order to pay off their loans before they retire…People who take out 30-year loans, by contrast, are generally less well established, with smaller down payments, and require a bigger slice of their incomes to make their payments.” Given the current economic climate, then, it makes sense that lenders are willing to offer a discount to those with an established credit history (i.e. 15-year borrowers), compared to those entering the market for the first time (i.e. 30-year borrowers).

As for those of you trying to decide which duration is most appropriate for you, well, that’s not an easy question to answer. In a nutshell, a 15-year mortgage will save you a tremendous amount of interest (more than half) over the life of the mortgage, but this is offset by a much higher monthly payment. There is also a psychological benefit of being able to pay off the mortgage sooner and not have to worry about spending the rest of one’s life making payments. Summarizes a Freddie Mac rep: “The thinking is that many baby boom mortgagors are taking advantage of the low rates to refi into a mortgage that will enable them to live a relatively care-free retirement life — i.e. free and clear of mortgage debt.”

But with any dilemma, the reality is much more nuanced. For one thing, the monthly payment associated with a 15-year mortgage is significantly higher. Accordingly, one might opt for a 30-year mortgage and simply repay it in accordance with a 15-year amortization schedule. In this way, one retains the flexibility to make the lower (30-year) payment if financial hardship strikes. This “insurance” is inexpensive relative to the overall mortgage, adding $50 a month for a $200,000 mortgage. Skeptics counter that few borrowers are disciplined enough to make the 15-year payment voluntarily and that for those facing financial hardship, making a 30-year mortgage payment will probably be just as problematic as a 15-year payment.

Other proponents of 30-year mortgages point to the extra interest as an advantage, since it is tax-deductible. One clever analyst thought he had figured out a way to save money overall with a 30-year mortgage by exploiting this loophole, but it turns out that the spread between 15-year and 30-year rates has widened to such an extent that “the math no longer works.” Once again, the skeptics rightfully point out that even if you can deduct 30% (assuming a relatively high tax bracket) of your mortgage interest, that still leaves 70% that you are paying to the lender.

Finally, there is also the possibility that interest rates will skyrocket, creating a possible arbitrage opportunity with a 30-year mortgage that wouldn’t exist with a 15-year mortgage. Basically, if you invest the funds that would otherwise have been paid to the lender in a high-yield savings account, you would end up with more money than you would otherwise have had if you simply opted for the 15-year mortgage. But these opportunities are pretty rare, and anyone who argues to the contrary is probably trying to cover up the risk associated with such a strategy.

In short, it’s reasonable to assume that a 15-year mortgage will save you money, compared to a 30-year mortgage. However, the higher monthly payment is an important consideration, and should not be accepted by those with uncertain financial situations. If, on the other hand, your income stream is relatively stable, and you’re eager to escape from under the burden of debt as quickly as possible, the 15-year mortgage is a reasonable choice.

Let’s start with the basics: What is meant by the term “assumed mortgage?” In a nutshell, the assumption of a mortgage is just what it sounds like- the transfer of all liabilities associated with a mortgage from one party to another. There are several variations, but it basically refers to a situation in which the buyer of a home assumes the existing mortgage from the seller, in lieu of taking out a new mortgage.

The benefit of such an arrangement is cost savings. Especially if interest rates have risen in the interim (i.e. in the time that has elapsed since the mortgage was initially obtained), the savings can be significant. Even with significant changes in interest rates, there are savings associated with not having to pay closing costs associated with obtaining a new mortgage. A buyer whose credit is less than stellar meanwhile, can avoid negotiating with a bank, and instead negotiate directly with the seller. Typically, any savings are shared between the buyer in the seller, and are simply tacked on to the price of the home.

Historically, mortgage assumption was only ever popular during times of interest rate uncertainty, namely the 1980’s and early 1990’s. At that time, many mortgages were assumed privately. In other words, the transfer was negotiated directly between buyer and seller, without the knowledge of the lender. Such mortgages are often structured as wraparounds, whereby the original mortgage is maintained by the original borrower, who receives payment from a new homeowner at a spread to the original borrower. Nowadays, such assumptions have become the exception, since lenders have caught on and inserted due-on-sale clauses into mortgages, which essentially required them to be repaid in the event of a change of ownership on the underlying property. Failure to notify the lender of a mortgage assumption, in such a case, qualifies as mortgage fraud.

Some lenders have become more amenable to mortgage assumption, such that they are willing to honor a transfer to a new borrower without assessing fresh closing costs. The catch is that in the process, the interest rate is ratcheted up to conform with prevailing rates. [Otherwise, the lender would deprive itself of the income that it could earn from charging a higher rate]. It should be noted that FHA and VA loans are always assumable, although those originated after 1989 require the approval (and payment of certain fees) of the lender.

If private mortgage assumption strikes you as incredibly risky, that’s because it is! While a public (i.e. lender-approved) assumption relieves the original borrower of all liability, private mortgages are off-the-record (and often illegal) and hence must be resolves directly between the two parties involved. Failure by the new borrower to make timely payments would place the original mortgager in the awkward position of playing landlord, perhaps to the point of executing a form of foreclosure. Meanwhile, mortgages that are assumed multiple times still leave the borrower (and his credit rating) on the hook until for as long as the mortgage remains existence, as one borrower learned the hard way.

In today’s ultra-strict lending environment, chances are you won’t ever have to deal with mortgage assumption. Given that rates are projected to begin rising, however, it could conceivably experience a modest surge in popularity. Still, for the average borrower, it’s not something worth considering.

Meanwhile, the average rate on a 15-year fixed-rate mortgage rose to 4.43 percent, from 4.37 percent last week, according to Freddie Mac. Rates on five-year, adjustable-rate mortgages averaged 4.4 percent, up from 4.38 percent a week earlier. Rates on one-year, adjustable-rate mortgages inched down to 4.54 percent from 4.6 percent. Points across all four categories of mortgages have remained constant at around .6.

Regardless of which survey you prefer, they all indicate that rates are rising. The consensus among analysts and industry insiders, meanwhile, is that they will continue to rise. “At a congressional hearing on Tuesday, MBA Chief Economist Jay Brinkmann said that the ‘most benign estimates are for increases in the range of 20 to 30 basis points’ but that some estimates of potential increases ‘are several times those amounts.’ ” The main reason for the projected increase has nothing to do with changes in the balance between the supply and demand for mortgages. Rather, it is grounded in the expectation that the Fed is planning to turn off the spigot of cash that has already spewed more than $1 Trillion into the market.

Typically, an inverse relationship exists between mortgage rates and home prices, such that when rates rise, prices fall. This is primarily due to the fact that borrowers work backwards when buying a home by first determining the highest monthly payment they can afford. With higher rates, the interest portion of the payment rises at the expense of the equity payment, which translates into a decline in the price of a home one can afford.

It is not clear whether that relationship will hold this time around, if/when mortgage rates finally rise. Home prices have actually ticked up over the last two quarters, and it’s possible that this momentum will be sustained. Unfortunately, this is not the view espoused by the majority of analysts. Robert Shiller, of the eponymous Case-Shiller Index, has discerned through a recent survey that a bubble-mentality has gripped many of the buyers wading back into the market. Anecdotal evidence also suggests that speculators have returned to the markets, en masse.

First-time buyers make up the other large contingent. When the tax rebate underlying such sales expires this month, chances are that this class of buyers will disappear completely. Even if Congress extends the deadline of the program, it’s likely that it won’t have much of an effect, since most of the determined buyers have already entered the market. Investors have already come to understand this notion, which explains why housing stocks are down nearly 20% from the summer highs.

“I’m a firm prophet of the ‘W’ shaped recovery. Housing is going to go down again in the first quarter of 2010. The real healing won’t begin until all these nonperforming loans start trading in earnest, until we get these borrowers back on their feet,” expounded one analyst. In other words, housing prices can’t recover until the economy recovers. Put another way, the housing market won’t return to normalcy until the financial situations of long-term, non-speculative borrowers have likewise returned to normal.

Personal finance columnists usually advise a down-payment of 20% Loan-to-Value (LTV). In other words, take the size of your mortgage, multiple it by 20%, and VOILA, you have your down-payment. According to their reasoning, 20% is substantial enough both to demonstrate your creditworthiness to the lender and to cushion you from negative price swings in the value of your home.

Given the decline in housing prices, however, it’s perfectly conceivable that borrowers that made 20% down-payments are still underwater in their mortgages. After a foreclosure, then, such borrowers will be left with stains on their respective credit report, and gaping holes in their personal assets. From the lender’s perspective, meanwhile, such borrowers are actually considered less credit-worthy than those that make the minimum required down-payment. For those of you scratching your heads: It turns out that those who make down-payments between 20-25% are actually more likely to default. In addition, such borrowers aren’t required to purchase private mortgage insurance, further increasing the cost of default to the lender.

The cost of private insurance, then, can actually be recouped in the form of lower interest rates! In other words, there isn’t much of a financial penalty (sometimes even a reward!) for making a smaller down-payment. Some financial planners now encourage making the smallest allowable down-payment, based on the reasoning that borrowers can then set aside extra money in an emergency fund, making it less likely that they will become delinquent (miss payments) on their mortgage further down the road.

What is the minimum down-payment? Well, that depends on the loan, and the lender. A Federal Housing Administration (FHA) loan requires a 3.5% down-payment. [However, proposed legislation would increase this to 5%]. For veterans, or those that live in rural areas, there are VA home loans and Guaranteed Rural Development loans, respectively.

For those not eligible for the loans above, it might be worth looking into a down-payment assistance program. Some of these programs are also government sponsored, and/or provide low-interest loans to be used exclusively for making a down-payment. There are also several not-for-profit companies which offer down-payment assistance, typically by rolling the down-payment into the overall loan amount, but such organizations have come under scrutiny in the wake of the collapse of the housing market. For first time home-buyers, the $8,000 tax credit can now be “monetized” and applied towards the down-payment. [Under earlier rules, the credit was received in the form of a tax credit, and hence, could not used for a down-payment.]

For those still struggling to scrape together the cash, there are a few more options available to you. First, you can talk to your lender and try to pledge securities in lieu of making a down-payment, but be advised that such is tantamount to borrowing money to buy stock. Second, if you already own the land that your home is (being) built on, that may qualify as a down-payment. Third, you can appeal to family/friends for help, but be aware that the lender will demand proof that any such assistance is a gift, rather than a loan. Finally, you might try talking to the seller, and asking him to help you make your down payment (offset in the form of a higher sale price). This will only be possible, however, if the sale price initially exceeded the appraised value.

All else being equal, a larger down-payment should translate into smaller monthly payments, as a result of both lower principal and interest. It should also lower your mortgage insurance premiums. As I noted above, however, some lenders actually penalize those who make larger down-payments. Ultimately, every situation is different, and it probably makes sense to use a mortgage calculator to crunch the numbers associated with a few different scenarios to see ultimately which one makes the most (financial) sense for you.

As almost everyone who takes out a mortgage is certainly aware, mortgage interest payments are tax deductible, which means the actual interest rate paid by the borrower is often significantly lower than the rate quoted by the bank. [The precise discount depends on one's tax bracket]. However, the understanding of most borrowers doesn’t extend much beyond this, which is problematic because it turns out mortgage-related tax matters are actually quite complicated.

For example, the tax benefit can only be claimed on mortgages under $1 million, and cannot generally be increased as a result of a refinancing, unless the proceeds are used to improve one’s home. Points, which are used to buy down the interest rate when the mortgage is first issued, are deductible in the year they are paid, as are loan origination fees. Lender fees, private mortgage insurance, and other settlement costs cannot be deducted.

As for home equity loans, the limit is $100,000. Paradoxically, the proceeds from a home equity loan cannot be used in relation to the home in order to be eligible for the deduction, but can be used for almost anything else, from credit card payments to school tuition, etc. If the borrower is subject to the Alternative Minimum Tax (AMT), however, the opposite applies, and the proceeds MUST be used towards the improvement of the home in order for the interest to be tax deductible. Confused yet? If so, the chart below represents the best summary of the IRS rules I have ever come across and should be a great reference when it comes time to file your taxes!

The IRS doesn’t make things easier. According to the GAO assessment, taxpayers have to go through as many as 13 steps to determine first whether mortgage interest is tax deductible, second whether points are deductible, and third the size of any deduction. Included in the official tax forms is a handy flow chart, which borrowers can theoretically use to complete these steps. However, the increasing majority of taxpayers that use tax preparation software to file probably doesn’t ever see this chart. To make matters worse, the GAO report found that such software uses inconsistent methods to determine tax detectability, sometimes even asking the borrower to make the determination/calculation himself.

The main purpose of the report was to assess the ability of the IRS to properly determine and manage mistakes in mortgage tax issues, and in this aspect, the report was scathing. Due both to inadequate resources and insufficient information about taxpayers’ mortgages, mistakes were often allowed to slide. Although, the GAO found that the claimed deduction was understated as often as it was overstated, so the net result is probably a wash for the government.

In any event, it seems clear that something has to change. Either the IRS has to streamline paperwork associated with the mortgage tax deduction, or the government needs to revamp the rules. When you consider that the deduction costs the government $80 Billion in foregone tax revenues per year – especially in the context of the current budget problems – this could conceivably become a major political issue.

The rate quoted above is the 30-year fixed rate, the benchmark of mortgage rates. It should be noted that this is a raw figure, as provided to Freddie Mac directly from mortgage lenders based on the rates paid by their customers. In this case, the average borrower paid .6 points to buy the rate down, which means that the par rate is actually higher. In other words, even if you have perfect credit, you can probably still expect to either pay a higher rate or pay a higher upfront fee.

Meanwhile, variable rate are currently running around 4.5% . If you opt for a 15-year fixed rate mortgage, you can expect to pay 4.46% interest (and .6 points). From this, you can see that the spread between 15-year and 30-year rates is a healthy .58% . In addition, since this lower rate is also spread over a shorter time period, the aggregate savings on interest will be significant over the life of the mortgage. (As an aside, there are other considerations in selecting a mortgage with a shorter term, namely whether or not you can afford the higher monthly payments. Especially given the current economic environment and the uncertain labor market, this is an important consideration.)

There are also wide regional differences concealed in the average figures reported by Freddie Mac, which can sometimes vary by as much as .3% from state to state. Recently, rates in the most distressed markets have tended to be lower than in healthier markets. This is perhaps explicable by lower demand for mortgages in states that have been hit hardest by the bursting of the housing bubble.

So, why have rates headed downwards? As I alluded to in the title of this post, it’s not for the most obvious reasons. In fact, mortgage activity is actually rising: “A four-week moving average that tracks mortgage application activity is up 1.7% overall.  Among refinance applications, that index is up 2.1%, while it’s up 1.2% for mortgage purchase applications.” In this case, an increase in demand hasn’t resulted in an increase in prices.

The reasons are manifold, but can mostly be found outside of mortgages/housing. For example, the Federal Reserve Bank has resumed its purchases of mortgage-backed securities (MBS) in recent weeks, as part of its program to stimulate both the housing market and the broader economy. Given that average mortgage rates rose when the Fed stopped buying MBS, and fell when the Fed started again, it’s obvious that this is an important factor. Another explanation can be found in US Treasury prices, which tend to lead mortgage rates up and down. Recent fears of a prolonged economic recession, low inflation, and a period of continued low interest rates have caused Treasury rates to sag ever closer to the all-time lows of 2008. Investors in MBS – from which the vast majority of mortgage rates are derived – seem to be taking their cues from low Treasury markets, and are buying MBS rates down proportionately.

Whether rates remain low, then, depends directly on the Fed and MBS investors. It seems unlikely that the Fed will continue to buy MBS in bulk, since all of those securities will have to be sold when the recession comes to an end. On the other hand, it’s conceivable that demand for Treasury bonds (and

MBS, by extension) will remain strong for as long as the economy remains weak. Still, as I wrote in the previous rate update, it doesn’t seem likely that rates will trend much lower, which means there’s no reason to delay if you’re thinking about taking out a mortgage or refinancing.

Many lenders take advantage of (borrower misunderstanding of) points in order to make it look like their interest rates are lower than their competitors, when in fact the difference can be explained entirely by the points. On the surface, paying points would seem like a great option, since mortgage affordability is generally calculated backwards, using monthly payment – rather than the size of the mortgage – as a starting point.

In this way, the numbers can be manipulated, such as to make it so a potential borrower can afford a larger mortgage simply by extracting an upfront payment in exchange for a lower monthly payment. Of course, this can also be achieved by simply increasing the size of one’s down-payment, but yields slightly different savings. Generally speaking, a higher down-payment is more economical in the short term, while using points to buy down the rate is only beneficial over the long-term.

So, how can you go about calculating whether it makes sense to pay points? This Points Calculator makes this question easy. Simply plug in the loan amount, points, interest rate, interest rate with points, loan term, and a realistic return on investment, and the calculator will quickly generate a break-even point- the amount of time it will take before you can achieve positive savings on your mortgage.

In other words, the points system inherently favors the bank over the short-term. It’s impossible to achieve savings from Day 1. Instead, you must plan on living in your home (and keeping your current mortgage) for a certain number of years before paying points becomes worthwhile. If you have every reason to believe that you will stay in your home longer than the break-even period, then it makes sense to pay points. Instead, if you plan on refinancing or “trading up” before the break-even period, it probably makes more sense to simply increase the size of your down-payment.

Another consideration is whether to roll the points into your mortgage, in order to avoid making a large up-front payment. This will significantly extend the break-even period and is only economical if your savings rate (i.e. expected return on investment) is higher than your mortgage rates, and your marginal tax rate is low. The latter is a factor because financing your points allow the tax benefit to be amortized over the life of the mortgage, while an upfront payment can only be deducted in the year in which it is paid.

Finally, it’s possible to temporarily buy-down your mortgage payment, such that you pay a lower rate for only a few years. The 2/1 buy-down and 3/2/1 buy-down are the most common and straightforward, with the latter reducing your interest rate by 3% in the first year, 2% in the second, and only 1% in the third year, before reverting to the stated rate. Typically, you shouldn’t expect to achieve savings from a temporary buy-down; rather the perceived benefit is that you can delay the normal payment for a couple years, giving your income a chance to catch-up.

Rates are now at their lowest-levels since the week of May 28, when they averaged 5.91%. Moreover, the decline has not been limited to 30-year fixed rates, which is the most popular type of mortgage, and hence the most oft-cited. “The average rate on a 15-year fixed-rate mortgage was 4.56 percent, down from 4.68 percent the previous week…Rates on five-year, adjustable-rate mortgages averaged 4.57 percent, down from 4.75 percent a week earlier.” One-year ARMS and jumbo mortgage rates fell proportionately.

While most analysis/prediction tends to focus on the demand side – implicitly seeking to establish whether mortgage rates are low enough to draw in buyers – it seems that the recent rate declines are a product of supply-side changes. By now, most laypeople are probably at least somewhat familiar with the securitization process (if not because of the pernicious role it played in the credit crisis), which bundles individual mortgages into large pools, in order to dissipate risk and sell them to investors.

Well, it turns out, that these pools of mortgages (known in industry parlance as Collateralized Mortgage Obligations [CMOs]), has been particularly strong in recent weeks. Investors are growing more confident (some would say complacent) about the risk posed by such securities, especially with respect to current prices: “Non-agency home-loan bonds have soared from record lows as investors reduced the yields they targeted amid signs that the deepest housing slump, worst financial crisis and longest U.S. recession since the Great Depression are easing.”

The US government (via the Treasury Department) and the Federal Reserve Bank have also been active. Specifically, there is “speculation that Treasury Secretary Timothy Geithner’s Public-Private Investment Program, or PPIP, will add as much as $40 billion of demand,” while the Fed’s “Holdings of mortgage-backed securities jumped $66.6 billion to $609.5 billion” last week, as part of its $1.25 Trillion plan to boost the housing market.

Going forward, it’s unclear whether these government purchases will continue. Already, the “Treasury and Federal Reserve said in a statement today that ‘they do not anticipate any further additions to the types of collateral that are eligible for’ the central bank’s Term Asset-Backed Securities Loan Facility,” which could make private investors wary of holding mortgage securities. Ultimately, such investments will only remain attractive if the housing market continues to stabilize and the foreclosure crisis is brought under control. Stay tuned…