One of the risk measures that lenders use in underwriting a mortgage is the mortgage’s loan-to-value (LTV) ratio. This is a simple calculation made by dividing the amount of the loan 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 private mortgage insurance (PMI) be paid by the borrower. That’s because a borrower who owns less than 20% of the property’s value is considered to be more likely to default on a loan.
- Private mortgage insurance (PMI) can be an expensive requirement for getting a home loan.
- Private mortgage insurance is likely to be required on mortgages with an LTV ratio 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.
PMI in Depth
Let’s assume, for example, 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), producing an LTV ratio of 90%. The monthly PMI payment would be between $117 and $150, depending on the type of mortgage you get. (Adjustable-rate mortgages, or ARMs, require higher PMI payments than fixed-rate mortgages.)
However, PMI is not necessarily a permanent requirement. Lenders are required to drop PMI when a mortgage’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.
An alternative to paying PMI is to use a second mortgage or what’s known as a piggyback loan. Here is how it works: 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 sales 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, you would take a 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 almost certainly carry a higher interest rate than your first mortgage. Although there are many types of second mortgages available, the higher interest rate is par for the course. Still, the combined payments for the first and second mortgages are usually less than the payments of the first mortgage plus PMI.
To sum up, 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:
Several other variables 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. The 2017 tax law has changed the limits on mortgage interest deduction, so check with an accountant concerning your financial situation.
- 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).
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? This is the overriding deciding factor and, therefore, the one we will focus on now.
Appreciation: The Key to Decision-Making
Here’s the most important decision factor: Once PMI is eliminated from the stand-alone first mortgage, the monthly payment you’ll owe 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 versus a 30-year fixed-rate first mortgage combined with a 30-year/due-in-15-year second mortgage.
The mortgages have the following characteristics:
Figure 1. Copyright © 2017 Investopedia.com
In Figure 2, the annual rates of home price appreciation are estimated.
Figure 2. Copyright © 2017 Investopedia.com
Notice that the $120 PMI payment is dropped from the total monthly payment of the stand-alone first mortgage in month 60 (see Figure 3) when the LTV reaches 78% through a combination of principal reduction and home price appreciation.
Figure 3. Copyright © 2017 Investopedia.com
The table in Figure 4 shows the combined monthly payments of the first and second mortgages. Notice that the monthly payment is constant. The interest rate is a weighted average. The LTV is only that of the first mortgage.
Figure 4. Copyright © 2017 Investopedia.com
Using the first and second mortgage, $85 dollars 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 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 demonstrated above. However, the following home price appreciation estimates are used.
Figure 5. Copyright © 2017 Investopedia.com
In this example, we only show a single table of monthly payments for the two options (see Figure 6). 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 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.)
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, it can be eliminated through an appraisal once the LTV reaches 78%.
- If you choose to use a combination of first and second mortgages, you are likely to have initial payment savings. However, the only way to eliminate the second mortgage, which will likely carry a higher interest rate than the first mortgage, is by paying it off or refinancing your first and the second loans into a new stand-alone mortgage.
If you can’t come up with a higher down payment or a less expensive home, calculate your options based on your time horizon and on how you expect the real estate market may develop. Nothing is fully predictable, of course, but this will give you the best chance of making the most favorable decision.