Read an interesting article recently about viewing paying PMI and viewing it as an interest expense on a diminishing principal amount (as you make monthly mortgage payments and pay down principal and your PMI stays the same, you're effectively paying interest (PMI) on a decreasing figure).
Example: Person buys $100K house, puts $5K down, and pays PMI until they reach $20K equity (one can comment on appraisal vs. 78% LTV, but you get the point). Let's say homeowner accumulates $5K of equity over the first few years, so now: $100K house, $10K total equity, $90K outstanding balance, $10K to go before reaching $20K equity and removing PMI (which hasn't changed). Let's say the PMI is $100/month for simplicity. $100/month x 12 = $1,200/year PMI.
$1,200/$15K to go = 8%
a few years later: $1,200/$10K to go = 12%
You get the point. The article is arguing that as someone is getting SO CLOSE to finally building up enough equity in their property, they're effectively paying an increasing interest rate on that difference and therefore should try to pay it down as quickly as possible.
I've always viewed PMI (assuming a conventional loan) as something that's paid up until a certain point and gone, but viewed it from the perspective as being for the life of the loan. So in this example:
Down Payment: $5K
Monthly PITI: $450 (rounding)
Int Rate: 4% (for simplicity)
N: 360 months
When PMI goes away (rounding): month 94
Total PMI payments (at $100/mo x 94 months): $9,400
Use APR calculator to solve for APR with "Extra Cost" of $9,400: to get 4.80% APR
What am I missing? How would you view this? Would you advise paying down principal to remove PMI or letting it naturally fall off and continue investing?
Certainly, it DOES make sense to me to pay down the principal quicker if you can, UNTIL you arrive at 20% equity and can request in writing for the PMI to be dropped.
But then afterwards, put any extra funds towards a NEW deposit - for a fresh investment!
Arguably, it's ALL about what ELSE you could be doing with those extra funds instead of paying down the principal. Be a shame to forego a SUPER bargain because of a current PMI concern.
These days however, doesn't the PMI attach to FHA low deposit Loans for the life of the loan? ie. would require a formal refi to pay it out each time? Cheers...
PMI does attach for the life of an FHA loan. And does require a formal refi. You would definitely want to find a lender who is doing a refi special so that you keep the closing costs to a minimum to do it.
I just look at how much the PMI costs and how much it would cost to have it removed.
So I have one property that basically just needs an appraisal. The PMI is $70/month. Appraisal might be $400. So that's a ~200% cash on cash ROI. No brained for me.
I have another property with PMI at $40/month. I need to pay down $10k and the PMI will go away. So that's a 5% ROI. I can do a lot better than that, so I leave it.
I just consider the PMI as an expense that I could eliminate at some price and see if I will accept the cash on cash return at that price.
Thanks, all, for your replies. My example assumes a conventional loan at 5% down (where the PMI automatically falls off at 78% LTV or 80% LTV w appraisal) vs FHA for the life of the loan now.
@Benjamin Richards , I like your approach. It seems then that it's all about cash on cash by knocking out PMI vs another investment and not so much about the article's view on the idea of paying an "increasing interest rate" (as the PMI payment remains constant while the amount to knock it out decreases with principal pay down).
Your question and analysis is spot on.
You definitely need to evaluate your cash on cash return for such a deployment of capital. I have PMI on my original rental property and right now I'm still about $20k away from being at the magical 78% Loan-to-Value. This IS an FHA mortgage but was done prior to the 'life-of-the-loan' requirement (which, by the way, makes FHA loans a bit more unattractive now in my opinion). I pay about $140 per month in PMI which is an 8.4% ROI if I pay the mortgage down to the 78% LTV. I'm able to get better returns through flipping/my other investments so I haven't paid it down. If that ROI number changes over time, I will reconsider.
Something else to consider is the tax consequences of such a pay down. Let's say your marginal tax rate is 25%. You're able to deduct PMI as a business expense. In my example of 8.4% ROI, we're really talking about a 6.3% ROI if I pay it down because now I'm losing those tax benefits and paying income tax on that additional cost savings.
I advise paying down the mortgage if you're unwilling/unable to secure any additional investments of a comparable return. However, I advise to NOT pay the mortgage down if you're able to outperform the ROI on the mortgage pay down. The answer always lies in the numbers on how one should proceed.
@James Triano , I agree with that. Makes sense. Two additional, follow-up questions though:
1.) Would it change your mind if the PMI was on a primary residence (non-investment/non-rental)?
2.) Do you think the part about viewing the PMI as interest at an "increasing rate" is a bunch of b.s. and just manipulation of perception?
Here's the link to the article I keep alluding to. Skip to the section on effective interest rate.
Mark - The reason folks would take a loan with PMI on it -- like an FHA loan -- is obviously because they can buy property with far less money down, thus getting into the game sooner.
To that end, PMI is a very reasonable cost associated with the enormous advantage of being able to buy property with $10,000, $20,000, or $30,000 less down.
Now to your point about it increasing your effective interest rate over the life of the loan - you are absolutely right. That's one of the key reasons I refinanced out of my loan as soon as I possibly could.
But there is a second point to the investor buying property using loans with FHA financing. And that is that if you pay off or build equity to the point where you can refinance your mortgage, you are then eligible to buy another property using an FHA loan.
In other words, refinancing out of an FHA loan increases your effective purchasing power, sooner.
Think about it - if you are buying $400,000 properties, it is far easier to get to 20% equity in a property than it is to save up the next 20% ($80,000!) for your next down payment, in an appreciating market (which happens the majority of years, but not all years).
If you buy a property, it means that you are statistically likely to get ~3-4% equity automatically through appreciation, and a few percentage points in loan amortization. Boom - that's 10% equity in the property after a year or two just by maintaining it. If you do some improvements to the property in your weekends or after work, you might be able to build 20% equity in just over a year -- this is what happened to me (though I did get lucky with Denver appreciation).
Guess what - I was then eligible to buy a $500,000 piece of property using an FHA loan just 15 months after my initial purchase, in spite of only having about $30-$40K liquid!
In my opinion, it is in the enormous purchasing power of being able to use ANOTHER FHA or low down-payment loan that the true benefit of refinancing out of your first loan materializes.
1) Yes, it would but only slightly. First, I'd probably opt for a way to not incur it on my primary residence, if possible. If I had it, I would evaluate my personal debt situation and pay down everything else I could (car, credit card, etc.) first. Then, I would do the same ROI calculation. If I can invest at 10% while the PMI is 8%, then invest, etc.
2) I think the increasing interest is actually real. Here's how I see it. If you have the ability to outlay cash up front in return for some payment (or lack thereof) in the future, then there is a calculable return. If your PMI payment is not decreasing proportionally to the amount of principal you owe, then that increasing interest holds true. In your example, the $100/month and $100,000 house, see the below calculations.
Year 1 - PMI - $1200; Amount to Pay down to 78% LTV - ($95,000 - $78,000 = $17,000) - $1200/$17000 = 7%
Year 5 - PMI - $1200; Rough Amount to Pay down = $13,000 - $1200/$13000 = 9.2%
Year 10 - PMI $1200; Rough Amount to pay Down = $8,000 - $1200/$8000 = 15%
Hope this helps!
@Scott Trench , some very good points indeed. In this particular case, what if you were looking at non-REI investments as the alternative to knocking out PMI on your primary residence. Let's say ROI of 8% average annual return. What would your thoughts be then?
At that point, it becomes an entirely different question of whether your ROI on paying down the PMI is more advantageous than deploying that money into the alternative investments. Seems to me that I might invest int he alternative assets until I had a lump sum large enough to throw into the property and pay off the PMI. Paying down the loan doesn't have any impact at all on PMI, until it is entirely refinanced, so the money is essentially uninvested if you just pay down the loan but are unable to refinance. That seems to have no advantage to me.
Basically, If I were in that position, I might invest in the thing I thought could get relatively stable 8% returns, until I had enough to pay down the mortgage to 20% of the property, and then refinance out of the PMI loan.
Interesting how mortgage insurance works in the U.S.A.
Here in Canada, when a borrower insures a mortgage though CMHC, or one of the private insurers, the insurance premium is a percentage of the principal being advanced (1.8% to 3.85% depending on the LTV of the note and the 'type' of downpayment) and is simply added to the initial principal (unless you elect to pay it up front).
viz. A first time homeowner purchasing a duplex for $105,000 and qualifying for a 95% LTV high-ratio, CMHC insured mortgage, the downpayment would be $5,250, leaving $99,750 to be financed. The insurance premium rate on the financing would be 3.6%, yielding an insurance premium of $3591. This gets added onto the portion of the purchase being financed for a total mortgage amount of 99,750 + 3,591 = $103,341.
With this approach, the borrower has incentive (since half of this property would be her/his primary residence, interest cannot be expenses) to pay down the principal more quickly, reducing the overall carrying costs of the mortgage.
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