How to Outsmart Private Mortgage Insurance

Barry Nielsen is the owner and operator of MortgageGraphics Inc. He has 20 years of experience in the mortgage and lending business.

Private mortgage insurance (PMI) is a type of insurance for mortgage loans that lenders may require borrowers to obtain. It protects lenders from borrowers who fail to make the loan payments.

No one wants 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.

Key Takeaways

• 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.

How Private Mortgage Insurance Works

One of the risk measures that mortgage lenders use in underwriting a mortgage is the loan-to-value (LTV) ratio, which is calculated by dividing the loan amount 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 the borrower buy private mortgage insurance (PMI). The insurance protects the lender since borrowers who own less than 20% of the property's value are more likely to default on the loan.

However, PMI is not necessarily a permanent requirement. Lenders are required to drop PMI when a mortgage loan'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.

On average, the cost of PMI can range between 0.5% of the loan amount to as high as 6% in some cases.

Example of Private Mortgage Insurance (PMI)

Let's say 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. As a result, your loan would have a 90% LTV ($270,000 / $300,000).

If the PMI cost was 0.625%, the monthly PMI payment would be about $168.75, but this can vary depending on the type of mortgage. For example, an adjustable-rate mortgage (ARM) typically requires a higher PMI payment than a fixed-rate mortgage due to the increased risk to the lender since an ARM rate and payment can fluctuate.

Second Mortgage Loan

An alternative to paying PMI is to use a second mortgage or what's known as a piggyback loan. 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 the 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 likely carry a higher interest rate than your first mortgage. A mortgage calculator can show you the impact of different rates on your monthly payment.

Although many types of second mortgages are available, the higher interest rate is standard. Still, the combined payments for the first and second mortgages are usually less than the payments of the first mortgage plus PMI.

The Tradeoffs of Using PMI

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:

1. 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.
2. 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 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. Consult an accountant regarding the Internal Revenue Service (IRS) rules for 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).
  

If you are a qualified veteran or servicemember looking to buy a home, you can avoid mortgage insurance and the down payment requirement by taking out a VA home loan.

Appreciation

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?

Here's the most important decision factor: Once PMI is eliminated from the stand-alone first mortgage, your monthly payment 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 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 about 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 about 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.)

Frequently Asked Questions (FAQs)

What Is Private Mortgage Insurance?

Private mortgage insurance (PMI) is a form of insurance you may be required to take out if your down payment on a home is under 20%. The PMI protects the mortgage lender from default on loan payments. However, you may be able to remove the PMI after a certain time as you gain equity in your home.

What Is a Second Mortgage?

A second mortgage is an additional lien on your home, which you are responsible for paying off according to the loan terms. A second mortgage can be taken out to avoid paying PMI on your first mortgage.

If I Put Down 20% as a Down Payment Do I Need PMI?

If you take out a conventional mortgage and pay 20% or more towards the down payment, you can effectively avoid the required PMI along with your mortgage.

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, an appraisal can eliminate it once the LTV reaches 78%.
• If you choose to use a combination of first and second mortgages, you will likely 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 afford a higher down payment or a less expensive home, calculate your options based on your time horizon and how you expect the real estate market to develop. Of course, nothing is entirely predictable, but this will give you the best chance of making the most favorable decision.