June 18, 2012

Why You Should Get Rid of PMI

If you buy a house with less than 20% down payment then you generally have to pay PMI or Private Mortgage Insurance.   Simply put, PMI is extra insurance you have to pay to protect the bank from potential loses.

PMI can be costly.   

I talked before about how much PMI costs and I briefly touched on how it how the true cost of PMI is often significant as a percent of the equity in question.   I think its a pretty important point so I wanted to elaborate on it.

If you're looking at paying $50 or $100 in PMI per month that may not seem like a huge amount.   Its just one of the various things you pay to buy a house.  You might have an $800 mortgage payment, $200 towards property tax, $50 for insurance and $50 for PMI.    But the thing is that PMI is really only based on the short fall in equity so this $50 or $100 charge is kind of like paying extra interest on the extra money you borrowed.     So if you go with a 10% downpayment instead of 20% on a $100,000 home then the difference is $10,000.   The PMI charge is an extra cost for that $10,000 difference.   $50 extra on a monthly payment for a $100,000 house doesn't seem as bad as $50 a month to borrow an extra $10,000.

Consider an example : Lets say you want to buy a house for $200,000 and only have $25,000 to put down.   Thats a large chunk of money but its only 12.5% rather than the 20% down you need to avoid PMI.    For such a loan you would end up paying monthly PMI of about $90.   That would cost you $1,080 over a year just for PMI.  If however you had an extra $15,000 in the bank that you could put into the loan you'd avoid that $1,080 annual PMI cost.   Effectively this means you're paying $1,080 yearly for that $15,000 difference.  This equates to a 7.2% cost on that money for PMI alone.   If you then add in the mortgage interest cost you're looking at another 4% for the mortgage you pay based on borrowing the extra $15,000.

Between the mortgage interest of 4% and the PMI costs equating to 7.2% you're losing 11.2% on the short fall in your down payment.    PMI is effectively costing you 11.2%.   Thats a horrible rate.

Worse yet, PMI doesn't go down as your equity increases.   So the % amount you pay on your equity short fall only gets worse and worse.   Lets say you get this loan with 12.5% down and keep making payments for a few years.   4-5 years from now you'll have made some principal payments which reduce the loan and increase your equity.   If you look 3.5 years down the road you may be on the verge of having 20% equity.   Looking at an amortization table in 3.5 years you would have a balance of about $163,000 which is just $3000 short of 20% equity on the original mortgage.  However you're STILL paying the same $90 per month or $1,080 per year PMI charge.   That means that you're paying 36% in PMI charges on the equity shortfall.   With the 4% mortgage interest you'd be saving 40%!  

So just 3 years into the loan and your PMI is costing you 40% on your equity short fall.  Would you voluntarily pay someone 40% interest?   Thats not a good idea.

It only gets worse from there.   Move forward 9 months when you're about 4 years and 3 months into the loan and you now owe about $161,000 on the loan.   Now you're only $1000 short of getting 80% equity.   That means you're $1000 short of being rid of PMI.    Yet you're still paying $90 per month on your PMI bill.   This is effectively 108% interest for the PMI on that $1000 difference in equity.   Plus the 4% mortgage interest charge and now at month 51 of the loan the  PMI is costing you a whopping 112%!    Clearly at this point it makes a LOT of sense to pay that extra $1000 towards your principal and get out from PMI charges.

Like I said before... PMI can be costly.

I should point out that 80% is not really a magical point that you get out of PMI.   I just used 80% to illustrate the example.   Getting rid of PMI is another story.  You may have to get an appraisal to prove the value of the home and your home would have to maintain its value or go up in value.   I'll cover more on how to get out of PMI in another post.


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