I have been meaning to write about private mortgage insurance for some time, but I got a little side tracked with focusing on the teacher side of my site. Understanding and expecting a private mortgage insurance (PMI) calculation in your home search is essential in your planning. I didn’t know very much about it, except that I’d have to pay it, when I started out my home buying process. I lucked out on a few occasions in my search for a home, including that my PMI is very low. I pay $12.07 for the PMI but some people pay $50, $100, or $150 monthly.
What is Private Mortgage Insurance?
Once upon a time, there was a simple rule that a person must have 20% of the home purchase price in cash in order to get a loan from the bank for the other 80%. If your parents wanted to buy a $200,000 house, they had to save up $40,000 of their own cash first. They went to the bank and said we have 20% of the purchase price of our dream home, can we borrow the rest from you? And that was how it was done.
If your parents didn’t have the cash, they didn’t get the house.
Now, it is not so. This is both a good and a bad thing. It’s up to you to weigh the pros, cons, and potential cons of being able to purchase a home without having 20% as a down payment. One consideration is the PMI.
There is a small misconception out there that a PMI is consumer insurance much like car insurance or health insurance. If you know only one thing, please know that a PMI does not protect you. PMI protects the bank or the lender. PMI is insurance on the mortgage and protects the mortgage. Since the bank holds the mortgage, it protects them, not you! Mortgage Insurance exists incase the borrower, i.e. you, defaults on the loan. So if you end up unable to repay your debt to the bank, they don’t lose out financially.
If you have less than 20% you must purchase and pay for Private Mortgage Insurance. Each lender has their own calculation chart, which isn’t exactly made public, but they generally follows a 5% gradient. So if you put 15%-19% down you will be charged a certain rate which will be less than if you put 10% – 14% down, which will be less than if you put 5%-10% which is really the lowest you should go. The mortgage broker I ultimately worked with to buy my house was very nice and said, “Hey can you put a little bit more down on your house so that you have 15% down? This way you will pay less on the PMI.” In my documents I had written some number which totaled about 14.7% of my purchase price. He didn’t have to do that; he could have just let me pay the higher rate in PMI. Know that if you are close to the next 5% increment, do what you can to put yourself over that mark. For me, it was only a few hundred dollars. I knew I could easily get that couple hundred bucks before closing. I had 45 days to do it. That’s 3 paychecks on a biweekly rotation.
How you should value PMI if you must pay it
The PMI in some sense has no value to you. You will never get anything out of it. Except that it allows for you to get into your home before you have 20% equity in the home. For me, that was critical. The neighborhood where I was renting had become unsafe rather quickly and I wanted to get out ASAP. The $12.07 extra I pay each month for the PMI is worth getting out of that neighborhood.
Generally, people wonder if they should continue to rent or buy a home. I live in an area where homes are not super overpriced and so it makes sense to buy. I never liked renting because it felt like I was throwing money away. That $600 in rent I paid for 2 1/2 years at my last rental – I will never see that money again. But the money I pay on my mortgage, some of it I will see again. The way I think about it is that my interest and PMI together is like a rent payment. It’s the money I’ll never see again and that’s just the price I pay to have a roof over my head. The money I pay on the principal, that money I will see again. Some financial experts, especially back in the day, promote a home as a type of savings account. It is an illiquid account of course, meaning it isn’t so easy to get the cash value out of it, but it is like a savings account none the less. One day, many years from now, when I go to sell my home, I get back all the money I have put in (so long as the market remains the same or goes up, we generally expect real estate to go up over time).
So I think of my PMI as part of my “rent” payment on this house. It’s the money that you pay just because you have to because everyone needs somewhere to live.
The Cost of PMI
As I mentioned above, the PMI charts for each lender aren’t exactly public. But when you go to a mortgage calculator, they’ll put an estimate on it. The Howard Hanna calculator has a footnote that “PMI is estimated at 0.5% of your loan balance each year.” Mortgagecalculator.org says to use 0.55%. I think this is a high estimate but when estimating it’s better to use larger numbers to ensure you can actually afford your home. My yearly PMI payment is about 0.2% of my loan balance. My starting loan balance was $76250, so $12.07 x 12 months = $144.84/$76250 =.001899… = 0.2%
You want to consider your monthly cost of the PMI. For me, 12 bucks, totally manageable, totally worth it. If you are paying 0.5% on a $200,000 loan your PMI might be $83.33 which may not be something you want to do. I know people who have paid $150 or more for a PMI. For me, over $100 is definitely not worth it.
Cumulative Cost of the PMI
The other consideration is how long you will pay the PMI because that tells you cumulatively how much you will pay over time. And remember this is money that is really no use to you besides getting you in a home sooner. If you can hold off on buying, it might be worth it. While you must pay a PMI if your downpayment is any value less than 20% of the home price, you will continue to pay the PMI until you have reached 22% equity in the home. Now you can request, in writing, that the PMI be removed once you reach 20% equity. But mostly what happens is that people don’t pay attention and it won’t automatically fall off until you reach that 22% equity point.
According to my loan documents, I can request that the PMI be removed after February 1, 2021. Assuming I pay exactly the minimum required of me it will take 3 years for me to reach 20% equity in my home. $12.07 x 36 months = $434.52. Less than on month’s rent at my old place! Now if I were paying $150, over three years I’d pay $5,400 which might have been worth a pause and a reconsideration of the purchase.
According to mortgagecalculator.org, with a 5% (where mortgage rates are currently hovering) interest rate and 15% down on a 30 year loan, it will take you 5 years to reach 22% equity, meaning 5 years until your PMI falls off. Lower that to a 10% down payment and it will take you 7.5 years until the PMI falls off. That’s 2 1/2 more years of a higher PMI payment. Switch to a 15 year mortgage and it will take only 1.5 years to go from 15% down payment to 22% equity.
Say you borrow $190,000 to buy a $200,000 home. You are putting down 5% and according to mortagecalculator.org, you will have a 0.78% PMI rate which comes out to $123.50. If you pay that for 9.5 years, you will have paid $14,079 in PMI. Woah! Is that worth it? Your options are 1) go with a 15 year loan 2) put more money on the downpayment 3) pay extra on your principal each month and do it fast 4) buy a smaller home 5) wait to buy a house. On a 15 year loan, you’d pay the PMI for only 3.5 years which has you paying a cumulative $5,187. But a 15 year loan means a larger mortgage payment overall. Kick it up to 10% down and your PMI would drop to $78 a month. Once more to 15% and PMI drops to $49.58. Every 5% more of a downpayment equates to $10,000. Do you have that? How long will it take to accumulate? All choices you must weigh against your personal situation.
Some Questions to Consider When Buying a Home
Buying a home is a big decision. It is probably the most money/largest debt you will ever spend. There are emotional components to buying a home but sorting out the logical/financial components can help soothe your emotional turmoil. if nothing else, you will feel more prepared for this big step.
Can I save up more in a downpayment to reduce or totally eliminate the PMI?
How long will it take me to save 5% (more) of my ideal home?
How much will that extra 5% reduce my potential PMI payment by?
As I save up that downpayment, how much am I throwing away in rent? Compare the potential cumulative PMI to the cumulative rent you’ll pay as you save up the down payment.
Is it more cost efficient to buy a home, pay the PMI, but potentially accelerate the mortgage payments to eliminate the PMI?
Do I need X dollar amount home or can I go with something smaller or in a different area?