What is PMI?
Private Mortgage Insurance (PMI) is lender’s protection in the event that a home buyer defaults on their mortgage. Typically, banks require at least 20% down for a home purchase. The purpose is to ensure that if the lendee defaults on their mortgage, the bank will be able to recoup its money back.
How Much Does PMI Cost?
The cost of PMI can vary. Most often it’s between 0.5% and 1.0% of the mortgage amount on an annual basis. PMI is paid in monthly installments and is in addition to the mortgage payments. The cost of PMI will vary primarily based on a combination of the Loan To Value (LTV) ratio, debt to income ratio and credit score.
The Bears’ Case on PMI?
PMI has a poor reputation; many see it as throwing money away. It increases your monthly payments without paying down your mortgage principle. In most cases, PMI does not go away until the LTV ratio reaches 78% or lower, meaning you have 22% or more equity in your home.
A Deeper Dive into the Numbers:
The cost of PMI will vary on a case by case basis. Let’s go through some hypothetical examples based on varying down payments or LTV ratios:
Chart is for illustration purposes only, actual cost of PMI will vary based on specific circumstances.
|% Down||Home Purchase Price||Down Payment||PMI % of Loan||Annual PMI Cost||True PMI Cost %|
The metric I like to focus on (and self-created) is, “True PMI cost %.” This is the annual cost of PMI divided by the additional down payment needed to forgo that PMI cost. For the 10% down scenario, it’s $2,700 / $60,000. If the buyer put an additional $60,000 down, the PMI would not exist. So, consider a couple who can afford to pay the extra $60,000. If they chose not to put down the full 20%, PMI can be considered as an interest only loan on $60,000 at 4.5%. However, for somebody only putting 5% down in the above example, the true cost of PMI bumps ups to 6.3% ($5,700/$90,000). An interest rate of 6%+ is something I would avoid, especially in today’s low interest rate environment.
Does PMI ever make sense?
In the proper situation, there can be times where taking on PMI is a smart, strategic move. After all, it does allow one who can’t afford to put a 20% down payment together, to still purchase a home. With the increased risk, there are a few questions I ask to help determine if purchasing a home and paying PMI is too risky: 1) Can you get the PMI cost on the lower side of around 0.5% of your mortgage? 2) How stable is your job and how employable is your skill set? The more replaceable you are and the tougher it would be to find a job if you were laid off, the less likely I am to recommend a home purchase with PMI. 3) Are you living in a single or dual income household? Dual income households provide some security as the income streams are diversified through two people. 4) How are your cash flows on a month to month basis? I believe PMI is a good candidate for people with healthy cash flow, that just haven’t saved up for a down payment. For example: a couple who aggressively paid off all of their student debt and will now be substantially cash flow positive. On the contrary, if one is barely cash flow breakeven, and only able to squeak by with the new home, PMI will put them too close to the edge for my comfort.
Traditionally, it takes several years of paying down your mortgage to get to a 78% LTV ratio if you are paying PMI. However, if your property is increasing in value, that time can be cut considerably. I worked with a client who got their PMI removed in 2 years. Her home value increased by 25% directly decreasing the LTV number well below 78%. She got the home reappraised, showed the appraisal to the bank and they dismissed the requirement to keep paying PMI.
Another consideration is, some banks offer a mortgage with no PMI if you put 15% down. That’s a big deal. If you were only planning to put 10% down, depending on the situation, it may be worth squeezing yourself for another 5% down.
A piggyback loan is an alternative to PMI. In this scenario, most commonly one puts 10% down, takes out a loan for 80% and takes a second loan, the piggy back loan for the remaining 10%. The piggyback loan is providing the extra 10% down to get the buyer to 20% down in total. This differs from PMI in that it does not go away once your LTV reaches 78% and it often carries a higher interest rate than your first mortgage. However, the structure is different as it still incorporates a principal payment into the monthly dues. Regardless of the differences, the similarity is that there is more risk to putting down less than 20% whether you pay PMI or take out a piggyback loan. If planning to put less than 20% down, I recommend sitting with your mortgage broker and/or financial advisor to analyze which option would work better for you.
Many view PMI in a negative light as the homebuyer makes additional payments just to have the opportunity to secure a mortgage. This is driven by the additional risk for the lender if the buyer cannot afford to put 20% down for a home purchase. However, PMI enables some to accelerate a home purchase. Under specific circumstances such as: healthy cash flow, limited debt, dual income, and/or job security, PMI could be a worthwhile option.
If you are thinking about making your first home purchase with PMI or would like to discuss your specific financial situation, schedule a meeting here.