The Game of PMI
In a recent article, we discussed how you do not need to put 20% down to buy a home. But when I tell people that, the very next thing they say is, “but I don’t want to pay PMI.” What is Private Mortgage Insurance, better known as PMI?
A few decades ago, if you wanted to buy a house, you needed 20% down. But then, the idea was born for an insurance option that would protect the top 20% of the loan for the lender. In the event of default, such as a foreclosure, that insurance would minimize the bank’s loss.
PMI was a win-win for the lender. They could make more loans, and the borrower would pay for the insurance in your mortgage payment! That doesn’t sound awesome for the buyer, does it? But is it really that bad? Your loan with some PMI might be better than next year’s 20% down loan. Plus, once you own a home, you’re building equity.
If you put down less than 20%, you will be paying a little more for that mortgage in some way. You can pay PMI in several ways, but how do you know which one is best for you? To shed light on that, let us give an example of a $400,000 loan and assume you’re putting down 5% with good credit.
Option 1: Borrower Paid Single Premium
This is where you show up on the closing table and write a check for $6,600 in this example. You take that money, give it to the insurance company, and never pay PMI again. Fortunately, you can finance this premium to keep your cash to close as low as possible. This option generally gives you the lowest payment, but unfortunately, that insurance only protects that loan. What if you refinance? What if you move in a couple of years?
Option 2: Monthly PMI
This is the most commonly used PMI structure, where you look at your mortgage statement and see a line item for Private Mortgage Insurance.
In this case, a $183 monthly increase to your payment. But one big negative is it’s not tax-deductible for most people. But a positive is it does disappear once you reach a 20% equity in the home.
Fannie Mae and Freddie Mac revised their guidelines to remove PMI in 2019. It will automatically fall off once you pay the loan down to 80% of the original sale price OR if you have 25% equity from an appraisal during the first five years of ownership.
Option 3: Lender Paid Mortgage Insurance
This is where the lender pays the Single Premium PMI, that $6,600 charge in option one above, in exchange for a higher interest rate. Although the mortgage rate is slightly higher, removing monthly PMI can save money. In this example, $50 per month. Of course, when you start mixing in tax savings, the difference can be even more significant. In this scenario, it could save about $1,000/year by choosing Option 3 and building the PMI into the actual interest rate.
Option 4: Combination Mortgages
This allows you to work around paying PMI entirely. The industry term for this is 80-15-5. That is where you finance 80% in one mortgage, 15% in a second mortgage, and the remaining 5% would be your down payment. The benefit here could be a lower payment. Second Mortgages typically have higher rates and adjustable rate features. Sometimes, they can be interest-only through a Home Equity Line of Credit. With a recent Fannie/Freddie fee passed onto mortgages with second liens, this structure is used less frequently today; however, it is popular with Jumbo Mortgages.
As you can see, you should not be so quick to say you don’t want to pay PMI. If you are thinking of waiting to buy a home because you want to save for a larger down payment, you should look at these lower down payment options. Always look at every option to see what is best for you. Once you talk through these options, your life goals, and market trends, you get tremendous clarity when choosing which path is best for you.
It takes 10 minutes for one of our mortgage planners at The Downs Group @ Vellum Mortgage to work up a comparison, so do not hesitate to reach out if you have questions. We are here to help!
