Put Your Money Where Your PMI Is04.30.2011
For most first-time homeowners, private mortgage insurance (PMI) is a necessary evil. It really doesn’t do a thing for you except allow you to own a home without putting down 20% of the cost up-front. The insurance is actually for the lender in case you bail on them.
Being the frugal fella you are, you have spare cash each month and you need to decide what to do with it. You probably have several options: pay down the mortgage, pay down student loans, invest in a retirement account, pay off credit card debt (credit card debt? but you’re a frugal fella, right?), or put it under a mattress. Whether you’re earning interest or paying interest, these can still be compared to find the most qualified suitor for your cash. Let’s take a look at some numbers, however accurate they may be, for each of these sinkholes:
- Pay down the mortgage: 5% (mortgage interest rate)
- Pay down student loans: 4% (student loan interest rate)
- Invest in a retirement account: 9% (rate of return)
- Pay off credit card debt: 12% (credit card interest rate)
- Put it under a mattress: 0% (rate of return)
Now, if you subscribe to the idea that you should put your extra cash in the one with the highest rate, this would lead you to believe you should pay down the credit card. Most people would stop there.
But let’s look at PMI. First things first: lenders are required by law to remove PMI once the balance of the mortgage reaches 78% of the original value of the property (given your payments are current). Technically they are able to remove PMI prior to 78% but that’s another story and we’ll play conservatively. Let’s say we purchased our home for $200,000 and so far we’ve paid the mortgage down to $165,000. 78% of $200,000 is $156,000 so we’re $9,000 from being free of PMI. We pay $100/month for PMI and our mortgage interest rate is 5%.
We may or may not have a full $9,000 to pay down our mortgage but, regardless, assuming so will more easily allow us to determine if this is where we should sink our cash. If we had the full $9,000, what would be the cost of putting it under our mattress versus paying down the mortgage? 5% of $9,000 is $450. This is the amount of annual interest we would save if we paid down the mortgage. Another way to look at it: this is the amount we would pay on annual mortgage interest if we stashed the $9,000 under our mattress instead. Now add PMI. PMI in our example is $100/month so over a year this tallies up to $1,200! Now let’s add the interest and the PMI together and we arrive at $1,650. This is the true opportunity cost/gain for the $9,000 with regard to the mortgage.
Now let’s calculate our opportunity cost/gain in the form of a percentage so we can compare it with our other candidates. $1,650 / $9,000 = 18.3%! The option of paying down the mortgage just went from 5% to 18% which is even higher than the massive credit card interest rate of 12%! Run the numbers for your own situation and see what you come up with.
Not So Fast
Before sinking all your extra funds into your mortgage to remove PMI, consider the following:
Pay-off cliff. PMI is somewhat of a different beast from interest. If we paid $1000 on our example mortgage we would immediately save ourselves from paying $50 each year on interest. On the other hand, the $1000 wouldn’t save us from paying the same amount in PMI until we paid all $9,000 that’s needed to get to the 78% PMI removal “cliff”. This causes some interesting effects. For example, the farther you are from the pay-off cliff the lower your opportunity cost/gain will appear for paying down the mortgage. Keep this in mind when paying down the mortgage as paying down $8,999 in our example is going to do you much less good than $9,000. Don’t run and pass out right before you reach the cliff.
Tax deductions. At least through 2011, mortgage interest and private mortgage insurance (PMI) is tax deductible though starts to phase out once your gross income reaches $100,000. Roughly, this means if your tax bracket is 25% then your opportunity cost/gain for the mortgage interest and PMI should be reduced by 25%. In our case, the 18.3% would more accurately be reflected as 13.75%.
Mind over math. Not all people feel you should pay down debts with the highest interest first. Dave Ramsey and other smart people like him believe that paying down debt is as much of an emotional game as it is mathematical. To get the emotional drive from quick, up-front wins, Dave recommends paying down debts with the lowest balance first–not necessary the highest interest.
Liquidity. Home equity is not a very liquid asset. In other words, if you lose your job and your kids are going to starve, it’s difficult to sell the house to feed their faces. Liquidity is itself of value and may be a great reason to store some savings elsewhere.
Vet your options. I’ve kept things pretty simple but life is good at throwing curve-balls. Make sure you understand the benefits of putting your money in each of your options. If your employer is offering a 401(k) match, that’s likely a 50% to 100% immediate return (keep vesting in mind) that should not be turned down. Likewise, there are tax advantages and implications all over the place. Be smart. My main goal of this article is to keep you from sweeping PMI under the rug and instead mathematically incorporating it into your financial decisions.