No one wants to have to pay private mortgage insurance (PMI) on a mortgage. It isn't cheap and it adds to the monthly cost of the mortgage. Figuring out whether you can avoid PMI starts with understanding why you might be stuck with it in the first place.
One of the risk measures that lenders use in underwriting a mortgage is the mortgage's loan-to-value (LTV) ratio. This is a simple calculation made by dividing the amount of the loan by the value of the home. The higher the LTV ratio, the higher the risk profile of the mortgage. Most mortgages with an LTV ratio greater than 80% require that PMI be paid by the borrower. That's because a borrower who owns less than 20% of the property's value is considered to be more likely to default on a loan.
- Private mortgage insurance (PMI) can be an expensive requirement for getting a home loan.
- PMI is likely to be required on mortgages with a loan-to-value ratio (LTV) greater than 80%.
- Avoiding PMI can cut down on your monthly payments and make your home more affordable.
- Anticipated appreciation of the value of the home is a major determining factor when choosing a path toward avoiding PMI.
PMI in Depth
Let's assume, for example, that the price of the home you are buying is $300,000 and the loan amount is $270,000 (which means you made a $30,000 down payment), resulting in an LTV ratio of 90%. The monthly PMI payment would be between $117 and $150, depending on the type of mortgage you get. (Adjustable-rate mortgages, or ARMs, require higher PMI payments than fixed-rate mortgages.)
However, PMI is not necessarily a permanent requirement. Lenders are required to drop PMI when a mortgage's LTV ratio reaches 78% through a combination of principal reduction on the mortgage and home-price appreciation. If part of the reduction in the LTV ratio is due to home-price appreciation, keep in mind that you will have to pay for a new appraisal in order to verify the amount of appreciation.
An alternative to paying PMI is to use a second mortgage or what's known as a piggyback loan. Here is how it works: You obtain a first mortgage with an amount equal to 80% of the home value, thereby avoiding PMI, and then take out a second mortgage with an amount equal to the sale price of the home, minus the amount of the down payment and the amount of the first mortgage.
Using the numbers from the example above, if the home you are buying costs $300,000, you would take a first mortgage for $240,000, make a $30,000 down payment and get a second mortgage for $30,000. This eliminates the need to pay PMI because the LTV ratio of the first mortgage is 80%. However, you also now have a second mortgage that will almost certainly carry a higher interest rate than your first mortgage.
Although there are many types of second mortgages available, the higher interest rate is par for the course. Still, the combined payments for the first and second mortgages are usually less than the payments of the first mortgage plus PMI.
To sum up, when it comes to PMI, if you have less than 20% of the sales price or value of a home to use as a down payment, you have two basic options:
- Use a "stand-alone" first mortgage and pay PMI until the LTV of the mortgage reaches 78%, at which point the PMI can be eliminated.
- Use a second mortgage. This will most likely result in lower initial mortgage expenses than paying PMI. However, a second mortgage usually carries a higher interest rate than the first mortgage, and can only be eliminated by paying it off or refinancing the first and the second mortgages into a new stand-alone mortgage. Presumably, you would do this when the LTV reaches 80% or less so no PMI will be required.
Several other factors can play into this decision. For example:
- Compare the possible tax savings associated with paying PMI versus the tax savings associated with paying interest on a second mortgage. Ask your accountant about the IRS tax rules on mortgage interest deduction.
- Compare the cost of a new appraisal to eliminate PMI vs. the costs of refinancing a first and second mortgage into a single, stand-alone mortgage. Note the risk that interest rates could rise between the time of the initial mortgage decision and the time when the first and second mortgages would be refinanced.
- Check the different rates of a principal reduction of the two options.
- Note the time value of money (the idea that money you spend now is worth more than the same amount in the future).
However, the most important variable in the decision is the expected rate of home price appreciation. If you choose a stand-alone first mortgage that requires you to pay PMI—instead of getting a second mortgage with no PMI—how quickly might your home appreciate in value to the point where the LTV is 78%, and the PMI can be eliminated? This is the overriding deciding factor and, therefore, the one we will focus on now.
Appreciation: The Key to Decision-Making
Here's the most important decision factor: Once PMI is eliminated from the stand-alone first mortgage, the monthly payment you'll owe will be less than the combined payments on the first and second mortgages. This raises two questions. First, how long will it be before the PMI can be eliminated? And second, what are the savings associated with each option?
Below are two examples based on different estimates of the rate of home price appreciation.
Example 1: A Slow Rate of Home Price Appreciation
The tables below compare the monthly payments of a stand-alone, 30-year, fixed-rate mortgage with PMI vs. a 30-year, fixed-rate first mortgage combined with a 30-year/due-in-15-year second mortgage.
The mortgages have the following characteristics:
In the table below, the annual rates of home-price appreciation are estimated.
Notice that the $120 PMI payment is dropped from the total monthly payment of the stand-alone first mortgage in month 60 (see table below) when the LTV reaches 78% through a combination of principal reduction and home price appreciation.
The table below shows the combined monthly payments of the first and second mortgages. Note that the monthly payment is constant. The interest rate is a weighted average. The LTV is only that of the first mortgage.
Using the first and second mortgage, $85 dollars can be saved per month for the first 60 months. This equals a total savings of $5,100. Starting in month 61, the stand-alone first mortgage gains an advantage of $35 per month for the remaining terms of the mortgages. If we divide $5,100 by $35, we get 145.
In other words, in this scenario of slow home price appreciation, starting in month 61, it would take another 145 months before the payment advantage of the stand-alone first mortgage without PMI could gain back the initial advantage of the combined first and second mortgages. (This time period would be lengthened if the time value of money were considered.)
Example 2: A Rapid Rate of Home Price Appreciation
The example below is based on the same mortgages as above. However, the following home price appreciation estimates are used.
In this example, we only show a single table of monthly payments for the two options (see table below). Notice that PMI is dropped in this case in month 13 because of the rapid home price appreciation, which quickly lowers the LTV to 78%.
With rapid home price appreciation, PMI can be eliminated relatively quickly.
The combined mortgages only have a payment advantage of $85 for 12 months. This equals a total savings of $1,020. Starting in month 13, the stand-alone mortgage has a payment advantage of $35. If we divide $1,020 by 35, we can determine that it would take 29 months to make up the initial savings of the combined first and second mortgages.
In other words, starting in month 41, the borrower would be financially better off by choosing the stand-alone first mortgage with PMI. (This time period would be lengthened if the time value of money were considered.)
The Bottom Line
If you are a borrower who has less than a 20% down payment, the decision of whether to use a first stand-alone mortgage and PMI or opt for a combination of a first and a second mortgage is largely a function of how quickly you expect the value of your home to increase.
- If you choose to pay PMI, it can be eliminated through an appraisal once the LTV reaches 78%.
- If you choose to use a combination of first and second mortgages, you are likely to have initial payment savings. However, the only way to eliminate the second mortgage, which will likely carry a higher interest rate than the first, is by paying it off or refinancing your first and second loans into a new stand-alone mortgage.
If you can't come up with a higher down payment or a less expensive home, calculate your options based on your time horizon and on how you expect the real estate market to develop. Nothing is fully predictable, of course, but this will give you the best chance of making the most favorable decision.