Measuring the Cost of Mortgage Insurance
My wife, Kelly, and I recently purchased a home and ideally wanted to put down less than 20% as a down payment. But doing so brought up the need for mortgage insurance. Being the analytical person that I am, I’m afraid that I may have possibly been a cumbersome client for my mortgage broker and real estate agent. After approximately 8,493 questions asked, I feel that I have a solid grasp on how to measure mortgage insurance costs.
Mortgage insurance (PMI) is provided by private insurers to protect the institution that lends you money in the event you can’t make your mortgage payments. It is typically required for loans in which a homebuyer makes a down payment of less than 20% of a home’s purchase price. If borrowers put down less than 20%, they are considered to be a higher risk to default on their loan.
Three Types of Mortgage Insurance
Mortgage insurance comes in three different forms:
1. Borrower-paid PMI - A premium payment is made every month until:
Your PMI is terminated at a 78% loan-to-value ratio,
You request to have it cancelled because the home's equity reaches 20% of the purchase price or appraised value, or
You reach the midpoint of the loan term.
2. Single premium PMI - The mortgage insurance premium is paid in one lump sum instead of in monthly installments. The entire premium can be paid when the mortgage closes or included in the amount of the mortgage.
3. Lender-paid PMI is actually single premium PMI that is paid by the lender. The lender increases the mortgage interest rate of the borrower throughout the life of the loan to compensate for this expense.
In all three of these forms, the homebuyer is required to pay for the protection of the lender. I don’t find this unfair, but I think it’s important to measure what the actual cost is so you may weigh all your options accordingly. (For related reading, see: Private Mortgage Insurance: Avoid It for These 6 Reasons.)
Where the calculations get a bit tricky is the most common form—borrower-paid PMI. Let’s look at an example:
Purchase price: $300,000
Down Payment: $15,000 (5%)
30-year fixed mortgage: 4.5%, $1,444 monthly payment
Required PMI: $150 monthly payment
Total monthly payment: $1,594
How do we measure the cost of the $45,000 that is being borrowed in order to make a 5% down payment instead of a 20% down payment? The easiest way to look at this is to split the 95% being borrowed into two loans:
80% of purchase price, no PMI required
$240,000 borrowed @ 4.5%, 30-year fixed
Total payment: $1,216
15% of purchase price, $150 monthly PMI required
$45,000 borrowed @ 4.5%, 30-year fixed
Total payment: $378
When looking at the total payment of Loan 2 and factoring in the $150 monthly PMI payment, the borrower is essentially borrowing $45,000 at a 9.5% interest rate and would need to pay on this loan for nine years before they reach a 78% loan-to-value ratio and their PMI payment is cancelled by the lender.
This calculation can help you compare other options available to you such as withdrawing from a brokerage account, borrowing funds from a private source such as a relative, utilizing a second mortgage, borrowing funds from a retirement plan or withdrawing funds potentially tax-free from a Roth IRA. For Kelly and me, it made the most sense to take advantage of a tax-free Roth IRA withdrawal and withdraw from our brokerage account investments. Our calculation had us paying over 10% when factoring in PMI, which is a high hurdle for an investment account to consistently achieve.
There is always more to consider than numbers when thinking about major life decisions such as a home purchase. Do your future self a favor and take the long view.