How to Outsmart Private Mortgage Insurance

How to Outsmart Private Mortgage Insurance

Private mortgage insurance (PMI) is something that no one wants to have to pay on a mortgage. It's not cheap, and it adds to the monthly mortgage payment. Understanding why you could be saddled with PMI in the first place is the first step toward determining whether you can escape it.

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The loan-to-value (LTV) ratio is one of the risk factors that lenders evaluate when approving a mortgage. This is a straightforward computation that involves dividing the loan amount by the home's value. The higher the LTV ratio, the higher the mortgage's risk profile. The borrower is required to pay PMI on most mortgages with an LTV ratio greater than 80%. Because a borrower who owns less than 20% of the property's worth is more likely to fail on a loan, this is the case.

TAKEAWAYS IMPORTANT

• PMI (private mortgage insurance) is a costly condition when obtaining a house loan.
• Mortgages with a loan-to-value ratio (LTV) of more than 80% are likely to require PMI.
• Avoiding PMI can help you save money on your monthly mortgage payments and make your house more affordable.
• When it comes to picking a way to avoid PMI, the expected appreciation of the home's value is a crucial deciding element.

In-Depth PMI

Assume the price of the home you're buying is $300,000, and the loan amount is $270,000 (which means you put down $30,000), resulting in a 90 percent LTV ratio. Depending on the type of mortgage you have, the monthly PMI payment will range from $117 to $150. (PMI payments on adjustable-rate mortgages, or ARMs, are greater than on fixed-rate mortgages.)

PMI, on the other hand, isn't always a need. When a mortgage's LTV ratio reaches 78 percent due to a combination of principal reduction and property price increase, lenders are compelled to reduce PMI. 1 Keep in mind that if part of the reduction in the LTV ratio is due to home-price appreciation, you'll need to pay for a new appraisal to confirm the amount of appreciation.

A second mortgage, sometimes known as a piggyback loan, provides an alternative to paying PMI. Here's how it works: You take out a first mortgage for an amount equal to 80% of the home's value, eliminating PMI, and then a second mortgage for an amount equal to the home's sale price, minus the down payment and the first mortgage.

Using the numbers from the previous example, if the home you're purchasing costs $300,000, you'd get a $240,000 first mortgage, a $30,000 down payment, and a $30,000 second mortgage. Because the initial mortgage's LTV ratio is 80 percent, there is no need to pay PMI. However, you now have a second mortgage, which is very probably going to have a higher interest rate than your first.

Although there are many different forms of second mortgages, the increased interest rate is standard. Nonetheless, the combined payments for the first and second mortgages are frequently less than the first mortgage plus PMI payments.

The Consequences

To summarize, if you have less than 20% of the sales price or value of a home to put down as a down payment, you have two fundamental alternatives when it comes to PMI:

Use a "stand-alone" first mortgage and pay PMI until the mortgage's LTV reaches 78 percent, at which point PMI can be removed.

Take out a second loan. This will almost certainly result in lower initial mortgage costs than if PMI is used. A second mortgage, on the other hand, usually has a higher interest rate than the first and can only be paid off or refinanced into a new stand-alone mortgage by paying it off or refinancing the first and second mortgages into a new stand-alone mortgage. Ideally, you'd do this when the LTV approaches 80% or less, eliminating the need for PMI.

This decision may be influenced by a number of different things. Consider the following scenario:

> Compare the tax benefits of paying PMI vs the tax benefits of paying interest on a second mortgage. Inquire with your accountant about the IRS's mortgage interest deduction guidelines.

> Compare the price of a fresh appraisal to get rid of PMI vs. refinancing a first and second mortgage into a single, stand-alone mortgage. Keep in mind that interest rates may climb between the time you make your first mortgage decision and the time you refinance your first and second mortgages.

> Check the different rates of a principal reduction of the two options.

Note the time value of money (the idea that money you spend now is worth more than the same amount in the future).

The predicted pace of property price appreciation, on the other hand, is the most critical variable in the decision. How quickly might your house improve in value to the point where the LTV is 78 percent and the PMI can be erased if you pick a stand-alone first mortgage with PMI instead of a second mortgage with no PMI? This is the most important deciding factor, therefore we'll concentrate on it right now.

The Power of Appreciation in Decision-Making

Here's the most crucial consideration: The monthly payment on the stand-alone first mortgage will be less than the combined payments on the first and second mortgages once PMI is removed. Two questions arise as a result of this. First, how long do you think it will take to get rid of the PMI? Second, how much money will you save if you choose each option?

Two examples are given below, each based on a different estimate of home price appreciation.

A Slow Rate of Home Price Appreciation is an example of a slow rate of home price appreciation.

The tables below compare the monthly payments of a 30-year, fixed-rate first mortgage combined with a 30-year/due-in-15-year second mortgage vs. a 30-year, fixed-rate first mortgage paired with a 30-year/due-in-15-year second mortgage.

When the LTV hits 78 percent due to a combination of principal reduction and home price growth, the $120 PMI payment is removed from the total monthly payment of the stand-alone first mortgage in month 60 (see table below).

For the first 60 months, $85 can be saved per month by combining the first and second mortgages. This equates to a $5,100 discount. For the remaining maturities of the mortgages, the stand-alone first mortgage gains a $35 per month edge starting in month 61. We get 145 if we split $5,100 by $35.

In other words, starting in month 61, it would take another 145 months for the payment benefit of the stand-alone first mortgage without PMI to equal the initial advantage of the combined first and second mortgages in this scenario of moderate property price appreciation. (If the time value of money were taken into account, this period would be extended.)

For the next 12 months, the combined mortgages have only a $85 payment benefit. This equates to a $1,020 discount. The stand-alone mortgage provides a $35 payment advantage starting in month 13. We may calculate that it would take 29 months to make up the initial savings of the combined first and second mortgages if we divide $1,020 by 35.

To put it another way, starting in month 41, the borrower would be better off taking out a stand-alone first mortgage with PMI. (If the time value of money were taken into account, this period would be extended.)

Final Thoughts

If you have less than a 20% down payment, the decision of whether to utilize a first stand-alone mortgage with PMI or a mix of first and second mortgages is largely based on how quickly you estimate the value of your property to improve.

If you want to pay PMI, you can get rid of it with an appraisal after your LTV reaches 78%.

If you employ a combination of first and second mortgages, you'll probably save money on the first payment. The only option to get rid of the second mortgage, which will almost certainly have a higher interest rate than the first, is to pay it off or refinance your first and second loans into one new loanloan stand-alone mortgage

Calculate your options based on your time horizon and how you expect the real estate market to grow if you can't afford a greater down payment or a less expensive home. Of course, nothing is completely predictable, but this will offer you the best opportunity of making the best decision possible.