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