With many of our younger clients who are purchasing a home for the first time (and some older clients as well), they face a critical question (in fact, this is a question that Anthony is contemplating himself): Should I delay the purchase of a home in order to save enough resources to get to the typical 20% down payment to avoid Private Mortgage Insurance (PMI), or should I simply purchase a home now and accept making PMI payments?
We have dealt with this question many times before, but we ran across a rather compelling analysis[1] created by a rather infamous financial planner, Michael Kitces, where he turns some of the traditional analysis of PMI on its head. However, since his analysis is rather complex (even for those in finance!), for this article we are going to focus on the basics of PMI, some best practices, and then turn our attention to the conclusions found in his analysis at the tail end.
NOTE: We are not going to discuss FHA loans, or a type of loan backed by the Federal Housing Administration (which is somewhat similar to PMI with some key differences). We will save this topic for another article.
What is PMI?
First, we need to explain the basics, including what PMI even is and why you should care about it if you are purchasing a home. You may have heard the general rule of thumb that you should save at least 20% of the value of the property you want to purchase. Why is that? Because you will avoid something called Private Mortgage Insurance. So what is PMI? Contrary to popular belief, PMI is actually insurance for the lender rather than the borrower (even though borrowers typically pay PMI). PMI provides protection for the lender in the event that you stop paying your mortgage (such protection is in place in case the proceeds from the lender’s foreclosure/sale of your property do not cover the loan balance, in which case the insurance will be paid out to the lender).
As noted briefly above, PMI is typically required by the lender if your down payment is less than 20% of the value of the home. In this case, the lender has less confidence in your ability to make your mortgage payment (and will thus default). For example, if you purchase a $600,000 home, you would need to put $120,000 down ($600,000*20%) in order to avoid PMI. PMI is based on the level of risk to the lender and typically determined by the size of the down payment (I.E. if you put down 15%, your PMI will typically be lower than if you put down 5% etc.), the value of the home (the more expensive the home, the higher the PMI), the location (new up and coming areas will have a higher PMI than an established area). However, your credit score is a VERY important factor (one of the most important for the larger insurers), and we will discuss this in greater detail below.
What are My PMI Options?
There are several types of PMI, including (1) a monthly payment paid on top of your normal mortgage payment (which ends once you reach an 80% loan to value); (2) a lump sum up front payment at closing; and (3) lender-paid PMI with a higher mortgage interest rate paid by you to cover the lender’s premium. We would note that PMI is typically a monthly payment, mainly because many people do not have the necessary lump sum available (as they have put down most of their cash down on the home) and generally lender paid PMI is a bit rarer. Thus, we will focus on the monthly payment PMI in this article.
Typically monthly payment PMI ranges dramatically based on your credit score (we would note that it is not the sole factor, as noted above). PMI can range from 0.3% up to 1.2% of the value of your mortgage (assuming an average to good credit score). To give you an idea of what mortgage insurance currently looks like (as of June 2018), we have provided a chart below created by the Urban Institute (a DC Think Tank) who gathered information from MGIC, the largest private insurance firm in the country.[2] This chart provides the mortgage insurance rates based on a variety of FICO scores (based on a 3-5% down payment on a 30-year fixed mortgage), and while this data is somewhat generic (there are many factors outside of FICO scores which can affect PMI), it provides some idea as to what your PMI payment will be.
As you can see, your PMI payment can vary dramatically based on your FICO score, and it very well can change over time (it is notable that if your FICO score is low, there has been a large increase in PMI premiums year over year, while the opposite is true if your FICO score is high). If we assume again a $600,000 home and a 5% down payment (of $30,000), your monthly PMI payments based on the above would range from $974-$1,068 per month for those with poor credit scores (620-659) and $261-$356 for those with good to great credit scores, with average credit scores falling somewhere in the middle. If we assume it takes about 84 months to reach an 80% loan to value, you can see the effect of having a good credit score – if your FICO score is on the lowest end, this could mean paying in total PMI of $104,064 vs. $25,056 on the highest end, or a difference of $79,008 over the life of the PMI period of 8 years. That is almost $80,000 of dead PMI weight, thus it really behooves you to consider your FICO score when purchasing a home with PMI, as such extra payments can be quite burdensome.
Quick Note – PMI Does NOT End Immediately When Expected
Before we move on, we want to make one quick point that people are not always told (or are told and do not remember). You would expect that once you have reached an 80% loan to value on your home, your PMI payment would automatically end. Unfortunately, this is not always the case – in fact, on most conventional mortgages, you can still be charged PMI until you reach 78% loan to value (without receiving such funds back) UNLESS you reach out to the lender and let them know that you believe you have reached an 80% loan to value.
You may have reached this point for multiple reasons. First, it may be the case that your home has increased in value over time, thus expediting when you reach 80% loan to value. For instance, if your $600,000 home five years into your mortgage shoots up to a value of $650,000 (when your mortgage balance is at $519,000), you would be under an 80% loan to value earlier than expected (with minor growth such expectation would be 7-8 years). In this situation, you would most likely need to prove to the lender that you have reached such threshold, and this may entail obtaining a professional appraisal of your home. This of course would cost you some money out of pocket ($400-$1000), but it will be worth it in this instance, as you would be saving yourself thousands of dollars; if we assume the lowest possible PMI payment on your home of $261 per month (per my previous example), getting out from under PMI earlier than expected can save you $6,000-$9,000 (and this is a low PMI payment – on the higher end, this could be savings of $26,000-$39,000!).
Piggyback Loan – Have Your PMI and Eat It Too! (Maybe)
Is there a way to avoid PMI altogether? Well, yes and no. In the early aughts, lenders were trying to drum up new ways of attracting homebuyers, and one way they discovered was the so called “Piggyback Loan.” This type of structure is actually a misnomer, since it is actually two loans – the typical structure (called a 80-10-10 loan) requires a 10% down payment, with the first loan (generally a 30-year fixed mortgage) for the first 80% loan to value, and the second loan “piggybacking” on the first loan for the remaining 10% (which is actually not even a mortgage, but rather a home equity line of credit). In our example, our $600,000 home will have a 30-year fixed mortgage of $480,000, and a HELOC balance of $60,000 for total debt of $540,000. This will allow the buyer to avoid PMI on the 10% that would typically require PMI.
As an aside, another interesting use of this type of structure would be to avoid a jumbo mortgage (and thus keep a conventional mortgage). This can be important, as a jumbo mortgage (loans above $453,100 in 2018) have more stringent credit requirements and potentially higher mortgage rates. Thus, in some situations, the piggyback loan structure will allow a borrower to put 10% down, borrow up to the limit of the conventional mortgage ($453,100) and put the rest on the HELOC to avoid having a jumbo loan.
While there are clear upsides of a piggyback loan (avoid PMI, potential to keep a conventional mortgage structure and thus obtain a potentially lower rate on the first mortgage), there are some downsides. First, you will generally need to pay closing costs on both mortgages (any origination fees and other administrative fees the lender charges). Second,
HELOC debt is also likely to carry a higher interest rate than the first. If the rate is substantially different, you may end up paying more for a piggyback loan than you would if you went with a traditional mortgage with PMI. Unlike PMI, which can be canceled once your loan value dips below 80% of the home’s value, the second mortgage does not go away until you pay it off. Third, you can run into trouble if you try to refinance your mortgages at some point. Generally, the second-lien holder must agree to take a backseat to the primary mortgage lender. If that doesn’t happen, you might have to pay off the second loan in its entirety before you can refinance. Thus, you must really understand what you are getting into if you are considering a piggyback loan, but for some individuals, it can be a really good way to avoid PMI and keep a conventional mortgage.
Is PMI the End of the World?
As we noted above, Michael Kitces ran an analysis on PMI that was quite compelling. He wanted to understand whether it made sense to put 20% down on your home vs. a 0% down payment (this was used for illustrative purposes, as typically you need to put at least 3-5% down on a home) and investing such dollars elsewhere.
He assumed in an example that a homebuyer (Jim) takes out a $200,000 mortgage at 4.5% on a home worth the same. He assumed PMI of $1,200 per year (or a PMI percentage of 0.6%). He would be required to pay down $40,000 to reach a debt to value ratio of 80%. Thus, he is paying $1,200 in annual PMI “interest” on a $40,000 loan (the amount he is paying PMI on), which equates to 3%. If we add in his mortgage rate of 4.5%, he would be paying a total annual interest rate of 7.5%.
If we simply look at these numbers from a return on investment perspective, he would essentially need to obtain a 7.5% rate of return on his investments in order to overcome the PMI/mortgage rate. Thus, it may seem as though Jim should pay down his mortgage quickly to get under the 80% debt to value threshold in order to avoid PMI, even if it means foregoing other types of savings (a similar argument can be made that Jim should have put a 20% down payment on his house rather than having PMI). Why? Because the 7.5% rate of return needed is a) a very high return to obtain from other investments and b) such “expense” through PMI and mortgage interest is “guaranteed” – no investment in the world today will have a guaranteed 7.5% rate of return, each investment (be it stocks, gold, other real estate etc.) will carry some risk.
However, the good news about PMI is that it is a short term payment – it will end at some point, and at that point, the return on investment needed is significantly lower. He assumed a 3% inflation rate and varying growth rates on Jim’s home and looked at how such factors affected the return on investment:[3]
As you can see, the longer the home is held for and the greater the home appreciates, the lower the return on investment needed (and thus makes it worthwhile to avoid delaying the home purchase, even if you have PMI). Why is that? In regards to the holding period, the longer Jim holds on to his home, the greater the effect that the 4.5% mortgage interest rate without PMI will have on the necessary return on investment, which will thus lower it. In regards to the home appreciation rate, the more the home appreciates, the better the home investment is in comparison to any other investments (and thus the lower the return on investment needed as a result). Thus, the longer you intend on holding the home (and if you are in a good area and expect a decent rate of return on your home), the less “painful” PMI will be long term. Of course, this does depend on the size of your PMI payment, which is based on a variety of factors that we noted above (size of down payment, value of home, location and most importantly your credit score), so it is important to take such size into consideration.
Buying a home is a very big decision, and PMI is but one potential factor. If you want to discuss any of the issues in this article further, feel free to reach out to either of us.
[1] Nerd’s Eye View Article: Determining the ROI of Eliminating Private Mortgage Insurance (PMI) with Principal Prepayments by Derek Tharp
[2] Urban Institute Article: The Private Mortgage Insurance Price Reduction Will Pull High Quality Borrowers from FHA by Bing Bai and Laurie Goodman
[3] Nerd’s Eye View Article Chart: Determining the ROI of Eliminating Private Mortgage Insurance (PMI) with Principal Prepayments by Derek Tharp
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors.
Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors.
*Licensed but not practicing on behalf of Lincoln Financial Advisors.
CRN-2186159-072018