Don't pay your down principal early- Keep PMI and Flood Insurance

39 Replies

I'm a number guy. I spend countless hours on excel spreadsheets running ProFormas on every possible situation. I want to know what the BEST possible outcome is, WORST possible, projected actual outcome, forced appreciation outcome, etc. I want to know if every single thing went wrong, what would it look like to my pocket book. And for giggles, I like to see if absolutely everything went 150% correct, how quickly could that accelerate me towards my goals. And, what steps do I have to take to force the latter option.

I constantly struggle between the Rush Limbaugh, no debt, and the maximum leveraged approach. I typically find myself somewhere in the middle, where I pay down a little extra each month, but I make sure that I have enough cash building up for my next financed deal. I think a lot of people fall here, and it is a reasonable approach.

I have run countless proforma's showing what the upside will be if I pay down my principal in record time. Its great! … on paper. I see, WOW! I could pay thousands less on interest over the course of 30 years. Or I could be debt free on this property 10 years early and that will quadruple my cashflow. All things that are VERY appealing. However, in running these proforma's I have recently discovered how much I am losing out on in the meantime.

I recently read Craig Curelop’s, Private Mortgage Insurance (PMI) Isn't All Bad, and it completely changed my way of thinking. Craig walks through 2 scenarios where one individual has an opportunity cost of building up enough funds to not pay PMI and the negative effects of this mindset. This was tough for me to grasp because I hated the thought of PMI.

I am currently in the process of finding my second house hack, a duplex – making Craig proud! I have landed on a potential property. The property is exceptional, and I am very excited about the potential purchase. However, there are two bruises rearing their ugly heads at me. These have taken quite a while for me to wrap my head around fully, even though the numbers work when I account for these! I cannot purchase the property at 20% down, so I will proceed with FHA financing, and PMI will be on the property for the life of the loan (assuming I don't refi, yada yada yada). Secondly, the property is in a flood zone. This one is particularly frustrating. Mortgage law makes banks require Flood Insurance on homes that are in FEMA flood zones. FEMA has not updated majority of these maps for years, but that is another complaint. I have had a difficult time accepting that I will have to pay nearly $400-500 per month additional for both of these combined. $400-500 out the door, not benefiting my principal, and hurting my bottom line greatly. All I get stuck on is that without these, I could make an extra $6,000 per year!

So, because of my personal need to run excessive proforma's to figure out exactly what I can do to better my situation, I determined, I can pay an extra $1000 per month (making this now a negative cashflow property), and make the property down 15 years soon! NICE! That means, in 15 years, I can cancel flood insurance, have no PMI, and now no financing! Perfect. I only need to put up with this for 15 years of a negative cashflowing property and then I'll be good! Right? But what am I losing in the meantime for these 15 years?

Like I said, the numbers work for me, cashflowing positively WITH PMI and Flood insurance. So, after reading Craig's article (mentioned above), it all finally clicked and I ran one more ProForma. This time, all I was looking at is the cost of financing, i.e. interest, PMI, and Flood Insurance.

As seen in the table, the purchase price is $380,000 and I am only able to put 6% down, bringing the loan amount to $357,200. And my current bank provided interest rate on a 30 year loan is 3.625%. At my first payment, my interest is $1,080 (rounded). I have received a flood insurance quote at $150 per month ($1,850 annual premium). And PMI is shown at .8% of the loan amount or roughly $240 per month. With all of this assumed above, I have shown the annual cost to financing this deal at $17,650 bringing me to an adjusted interest rate of 4.94% of the loan.

Yes, I thought I had a win with a 3.625% interest rate, and it hurts to see that interest rate at a 4.94% rate! But when I saw this, it made me realize, I can make more money through simple index fund investing (read Scott Trench’s Set for Life) and other real estate deals that beat my 4.94% interest rate. Not to mention, this rate will decrease as PMI decreases; although minimal, there is still an upside. So, if I were to stick with my original plan of dumping excessive cash into this property to get the loan paid off in record time, I would only be beating a 5% interest rate, but losing higher yield investment opportunities. Right now, I can count on index funds being between 7-9% and certain real estate deals as much as 11-15%. This has completed changed my mindset on debt leverage and the potential upside that I have.

With Flood Insurance remaining roughly the same and accounting for inflation and PMI decreasing over the life of the loan, I could expect to pay roughly $100-130k from these to costs alone. Now, if I choose to invest that $500 per month ($6,000 per year) instead of putting it towards principal the benefits could be astronomical. With the beautiful thing they call compound interest (the extend of which is not covered in the scope of this article) on an average of 8% on index funds I could see over $600k in 30 years. Or at a 12% return in real estate investing, I could see nearly $1.5million in 30 years.

In summary, I am an over analyzer as I like to see all options of every deal. That being said, don't shy away from PMI and other financing incurred expenses, if your deal is cashflow positive. They can be extremely discouraging at first, but if you look at the macro-level picture, it can be easy to tell that you still have a great opportunity to succeed. With easy index fund investing and real estate networking deals, explore all of your options to determine if these expenses are just a cost of doing business. Because the worst deal here, is no deal at all. It can be a tough pill to swallow, but you have to spend money to make money.

@Cameron O'Connor great write up and 100% agreed. Leveraging with the least amount down (and even with PMI when applicable) is worth it 99.9% of the time in this current economy/interest rate environment. The more capital you have in your pocket allows you to obtain more doors, and you will come out way ahead in the long run versus putting a larger down payment each time. It's not the popular opinion by old schoolers, but the math wins.

Leverage is all GOOD...  Until it isn't.  All the spread sheets in the interverse won't do a bit of good when things go sideways.

Remember, leverage is a two-edged sword.  A little bit of cushion for the pushin will go a long way.

@Zack Karp , thanks Zack! Conservative leveraging is key. I think people hear leverage and they think of the risk when the next recession hits. Most all of these mortgage expenses are fixed rates and won't change for 30 years. Your risk is mitigated and allows you to diversify and grow quickly.

@Marc Winter I hear you loud and clear Marc. However, my cushion is built into my monthly expenses. Assuming all CapX, maintenance, vacancy, management, taxes, etc. fees are included in a conversative manner the cushion is there with little concern for fluctuation. All of the expenses listed in this article (with the exception of insurance) are fixed for 30 years. Insurance can increase, and will increase, but with flood insurance programs being Federally mandated, they are under strictly guidelines. And as long as I'm purchasing this property with the long term in mind, I could care less if the market plummets in 2 years or 5 years, or 3 days. My net worth may look less on a balance sheet, but it in no way effects my cashflow, as long as I can fill this property with good tenants.

@Cameron O'Connor see I disagree with conservative leveraging.  Max leverage is the key imo.  When talking about long term investment properties at low interest rates, who cares?  If you are buying a property, living in it for a year to get the low down payment, then converting to a rental property, your tenant will be paying the mortgage for the next 30 years until it's paid off.  So who cares what the property is worth in 1 year, 5 years, 10 years, etc.  This is where people messed up in the last recession.  They panicked when the bubble hit, property values tanked, and they short sold or foreclosed when they were underwater.  Instead, if they would have just kept renting them out, eventually inflation would catch back up, even if it took 20-30 years.  And in the end, you have a free-and-clear asset that you purchased with a low down payment and your tenants paid for the whole thing.

Obviously I am way over-simplifying it, but the point is that people doing buy and holds shouldn't be scared of a bubble, and the math wins with max leverage over a long period of time with what you can do with the rest of that money.  The only people that should be concerned with a bubble are flippers and people looking to actually sell their primary residence in order to upgrade, downgrade, or relocate.

@Zack Karp  Maybe conservative leveraging is a poor choice of words. I completely agree with you there. I had nearly the same response to Marc just prior. By conservative, all I meant was make sure the property is a cashflowing positive with ALL expenses accounted for including Vacancy, Capx, maintenance, management, etc. I think a negative cashflow is not worth the money, even if the appreciate MAY get there in years to come. That is more of a gamble in my opinion. Leverage your purchases, with ALL expenses accounted for, and the only thing you should be worried about is getting vacancy's filled.

@Cameron O'Connor and @Zack Karp , I hear you guys!  Especially towards the start of investing when the lessons of a past recession or bubble have been studied, but not necessarily personally felt.  

It all sounds good as long as you can hold on and "if they would have just kept renting them out, eventually inflation would catch back up, even if it took 20-30 years".  I get where you are coming from.

But life has changes associated with it.  Two or Five or more years from now your life situations will change--hopefully for the better, but who knows?  What if the market isn't ready BUT YOU ARE ready to move on?

I am ABSOLUTELY POSITIVE about real estate--it has been the greatest thing that ever happened to me business-wise and I am totally POSITIVE about the future.  

That being said, I found a bit of reality check from time to time and a bit of a financial cushion will make a GREAT sleep aid when other 'investors' are losing their minds.  It will happen--the question is just when?

Good luck to everyone! 

 

@Marc Winter agreed.  If you are going into it thinking that you might need to sell or refinance at some point, then yes those points are absolutely valid.  But if you are going into it thinking that these are forever buy and holds, that's where I was making the point that long term investment properties are virtually recession-proof, and those investors should not be worried about a short-mid term bubble.

But yes, life does throw curve balls, and everyone's journey is different!

I like this discussion, decent points being made regarding risk, but wanted to point out that real estate tax rates, insurance rates, cost of repairs, etc., do rise, sometimes jump unexpectedly, and the plan of just keeping good tenants may not always work in a downturn. Remember if the economy is hurting, renters are too, not just homeowners. When your tenant loses his job and stops paying, and you're max-leveraged, problems start. Many landlords weren't walking away because it was a choice of just keeping it rented or walking away when value fell. Their tenant couldn't pay and hung on as long as possible as nowhere else to go, over-leveraged landlords couldn't make payments with no rents coming in, and values plummeted so they couldn't sell, either. And flood insurance is a mess -- it's not a set cost until they actually solve it. The one unit I have that requires flood started at about $300/year, then went to $800, now about $600/year. If the numbers work, put as little down, pay PMI, etc., as you wish, but make sure that whatever else your invested in allows you to quickly pull out at least 3-6 months of mortgage payments for all property you own, and make sure it's somewhat stable and won't tank, too, in a downturn. While I don't see another serious downturn happening in the near future, not many saw it the last time, either.

@Lynn M. Thank you! I think the best part with being able to put less money down, again if the numbers work, this allows you to keep a cash back up fund. You can hold 3-6 months of your mortgage, or more if you don't have to put as much down, on top of the vacancy rate that you should already be accounting for in your expenses. This can help you wade through the downturn and give you just enough cushion to ensure you can get a quality tenant in even if it takes a couple extra months.

@Cameron O'Connor Nice thread. Help an old guy out please. I've paid cash for 19 SFHs over the past 11 years and generally come in around around 10% ROI. Not a great ROI, but safe and steady for an old guy.

I'm running the numbers for my 30 year old son purchasing a new $125K SFH with $10K down and 3.7% APR / 30 years, renting it out at $1,125 and I will PM for him at not cost. My numbers show he will cash flow around $300 a month and build $2K in equity over 12 months year 1. That's around $6K in wealth with an ROI around 30% the first year. I' surprised how large the ROI is. Am I missing something or does this surprise you? Best, Terrell

@Zack Karp I appreciate your comment on how max leverage can be useful for buy-and-hold investors, and certainly if a property is not being sold and tenants are still available to pay the mortgage + expenses, then it's not a terrible situation to simply stay put until the market rebounds.  However, there is still a potential downside to being max leveraged from an opportunity cost perspective.  Take the example of a market downturn where property values plummet.  This will mean that I will have little to no access to capital within my asset portfolio to gain some once-in-a-lifetime opportunities on some really discounted properties to add to my portfolio.  If I have sufficient cushion in my property values such that I could still sell a few or tap into the (albeit less) equity of my properties, I may still be able to purchase new properties that will accelerate my LT growth plans.  To me, market downturns are an excellent way to accelerate my wealth and I want to be prepared to invest during those periods (because we all know they are coming).

@Cameron O'Connor Rush Limbaugh doesn't offer investing advice. He is a conservative radio show host. Dave Ramsey talks about low debt strategies. The fact that you don't know his name tells me, you have no real understanding of his teachings. I would recommend reading his books before you dismiss his approach. Beyond his teachings on debt, his advice on keeping a budget and reducing spending is more valuable in my opinion.

I agree with your overall conclusion that leverage is good when younger, but I would reconsider a couple other things you stated.

First of all, flood insurance is required by FEMA because that is the organization left helping people when their house is destroyed by flood. Floods are a very real concern for investors. People make the mistake of believing that properties in a 100 year flood zone happen every 100 years, so they dismiss the risk. The truth is a 100 year flood zone is actually a 1% chance of a flood happening every year. That means there is a 1 in 100 chance and the odds are the same every year, so even though you had a flood last year, it could happen again this year. It is like flipping a coin. Each flip has a 50% chance of heads or tails, but if you flip it 100 times, the results will rarely be 50/50. Getting rid of flood insurance when your property is in a flood zone is a horrible idea. Honestly, I would never even buy a property in a flood zone. Even beyond flooding, it reduces property value, which is probably why you were attracted to it (same reason others avoid it).

You also mentioned investing money in index funds versus paying down debt. Keep in mind that index funds may average 7-9% but there are specific years or event times of the year that you could invest and end up loosing money. From January 1 to December 31st the market index may have gone up 9% but if you put your money into the market in June, you may only be up 1%. The market is up and down, not a fixed return. A loan is a fixed rate. 

The other problem is those years the stock market has loss. For example in 2008 when there was a 38% drop. If you had $1000 before the drop, you would end up with $620. Even if the market averaged 10% every year after that, it would still take you over 5 years to get back to that $1000. So over that 6 year period your rate of return would be 0%. 

I prefer the idea of reinvesting the money into another down payment. You can't beat the return that you can get on leveraged real estate. If you buy in a good location, I see housing as a safer investment than the stock market.

Just to be transparent, I have money in the stock market, but it is in tax advantaged retirement accounts. I plan for it to sit there for 30-50 years. For that reason, I am not concerned with ups or downs. Even a major down spike sees recovery over 10+ years. For me it is about diversification. My point is if the money is going in the market, make sure it is meant to be there long term, otherwise hold it in safer short term investments.

So I don't see an issue with PMI to keep your cash into the deal low, but I would reinvest that cash in real estate. Putting some cash into a tax advantaged stock market investment is fine as long as it is super long term.

@Vincent Gurko Analysis can be great, but sometimes a curse, as I fall into analysis paralysis. None the less, I enjoy running numbers so often that, frankly, practice time and time again is how I have developed this skill. 

I would say a great start would be to watch @Brandon Turner 's webinars on how to analyze a deal. He has a way of explaining things in the simplest of ways. And then take what you learned from there and going to zillow or realtor.com or some online listing broker and analyze a deal daily and blindly. Even if you have no interest in investing in the specific property of region, just run the deal and you may be surprised. This can also quickly open up a lot of resources and how to find great tools in certain areas.

@Grant Liddle I think you missed the concept.  If you are putting less money down in the first place, that is the access to your capital right there.  You don't need to wait to pull cash out later or sell the property, because you never put that money into the property in the first place.  Why put the money down, only to pull it back out later?  That is an unnecessary step that comes with extra costs too.

Hope that makes sense.

@Zack Karp I mis-understood your comment about max leverage. I was assuming this was applied across the entire portfolio such that all (or majority of) capital was being used to invest in properties. If maxing out the LTV ratio on a single property to conserve available capital and act as a cushion that way, then that makes sense, and I agree it is always easier to pull money from my pocket than it is to pull it out of an asset.

Thanks for the clarification!

@Terrell Garren Terrell, well I can promise I don't know all of the answers, this is just one of my recent findings that I enjoy sharing. I would say your strategy of a 10% ROI with no debt is a fine strategy, just not necessarily one I partake it. You are likely seeing this as a lower ROI as you have way more cash in the deal than your son who will only have 10k into it. While you are making way more per month because you are not financed, it is much smaller in comparison to the amount of money that you initially invested with a cash purchase. I would say your son's 30% ROI is very likely. Maybe $300 per month is a little high in my opinion, probably closer to 200 after vacancy, capx, etc, but I do not know any of the specifics. None the less still right around your 30%.

On a similiar note, if you have read @Brandon Turner 's book on Investing with Little or No Money Down, you will see if you do a deal with $0 of your own money, your ROI would be infinite. It is all relative to your initial skin in the game.

Best of luck to you and your son!

@Joe Splitrock thanks for reading it! You got me on the name mix up, that is for sure! But you are correct, I do not follow Dave Ramsey, particularly close. And my reference to him in my article was merely just referencing his commonly known belief that no one should have debt. Where as I am saying good debt is GOOD!

In regards to the flood zone, I agree, there is absolutely risk there. But aren't there always risks of a fire, earthquakes, tornadoes (especially in Indiana, where I am from), or other natural disasters. Risks are inherent in any industry and I think they need to be evaluated and take case by case. In this specific case, a several mile long levee has been built, the elevation of this specific property is higher than surroundings, and this property is located right on the cusp of the FEMA determined flood zone. I'm not denying the fact that a flood could get consume this property, but yet I look at it as what would my damage be. The basement is unfinished, so I would only be replacing 10-20k in equipment. The first floor is about 3 feet up, which based on this elevation would be equal to that of a property outside of a flood zone.

And regards to the index funds, I am looking at all of this in the long term gain. People that had to sell homes, stocks, anything in the down-turned market suffered a serious loss. Yet those that were able to hold through it have now seen significant gains even when buying at the peak before the crash. Any investment in the short term is alway much more risky than that in the longer 15-30 year range, which is the same loan duration as putting the house on a 15-30 year fixed rate mortgage.

And lastly, I completely agree, I only use the stock market (aside from a retirement account) as a tool to build cash until I have enough money for my next down payment on a property. Because I cant stand the banks .01% interest, which is losing money from inflation as it sits in my account. Although this last portion paragraph is contradictory to what I just stated with long term investing, this is just a personal choice of mine to get a 5-10% return, to more quickly build up my ability to put my next down-payment on a property. With this, though, I do have the full understanding of potential loss from a falling market, at which time I could pull that out and put it into a savings with no interest. 

@Cameron O'Connor Honestly, the simplistic way I looked at this is having a balanced approach that is dynamic with age. 

With our small multifamily stuff, we are looking to pay down gradually over time because those are going to the family estate and kept in the family. 

The reality as one gets older you get more concerned with higher cashflow than when younger.

I agree with @Marc Winter and @Joe Splitrock . Interesting read and well written Cameron. 

Cameron, thank you so much for bringing this topic up. It came just at the right time for me. I am refinancing now on my 2 unit in Los Angeles to bring my interest rate down. I have the option to go with PMI of $109 (currently $218) and only pay 4k for my refinance. Or put in an extra 35k on top of the 4k in order to reach 20% equity and remove the PMI. The 35k scenario would save me the $109 PMI and $155 off the mortgage since I'm dumping 35k into it. So total savings of $264 per month. I thought this would be worth the 35k investment but now that I think about it, boy am I wrong. With that 35k down I can make cashflow on another property equivalent to $264 per month, plus I would gain equity in paying the principal!! This really helped me out.

@Cameron O'Connor

Not sure how it fits into your calculations but remember a property mandated to have flood insurance is worth less then same property outside flood zone.

A $400k home here with a community flood policy ($2500year) would be worth close to $500k outside the flood zone.

Guess there is an argument somewhere for the affordability of a property in a flood zone vs non flood zone..... of course taking on more risk in flood zone

P.s. The whole flood insurance system is out of whack and needs to be reworked. The calculations just dont make sense and premiums are way off.

I have a 600sf rental that never flooded but the policy is $2600 a year.

I just sold a property that was 1600sf (almost 3 times the size) that flooded severely and the policy was $2200.

@Ola Dantis thank you for the kind words! I hear where you are coming from. And, frankly, there is not a one-size-fits-all approach to investing. This is how I feel currently at my age of 25, but I am entitled to change this at some point when don't need acquire any more properties and would prefer have more equity in each. So, I agree with your statement of this is a dynamic approach depending on age. Thanks!

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