A Mortgage Cost You Now Can Do Without
For those who've gotten a mortgage in the past few years with little equity, most are all too familiar with private mortgage insurance, the added premium built into the mortgage payment insuring the lender against payment default. Measured over time, it can cost you thousands, so it's worth a closer look -- especially if you can eliminate it entirely.
There Are No Longer Tax Advantages: For years, mortgage borrowers got to enjoy additional tax advantages by having the ability to write off their annual mortgage insurance premiums -- much like their property taxes and mortgage interest. A dollar-for-dollar write-off, paying PMI wasn't all that bad.%VIRTUAL-pullquote-If an appraisal of the property you're going to buy shows you have 10 percent equity, you could qualify for the lender to pick up the monthly mortgage insurance payments, aptly called Lender Paid Mortgage Insurance.% From 2008 through 2013, it was simply the cost of doing business if you didn't have the holy grail 20 percent down payment. Then the IRS changed the rules, and disallowed the mortgage insurance premium deduction for taxable years after Dec. 31, 2013. As we enter the fourth quarter of 2014, many homeowners are not privy to this change, and will learn that their PMI is now an after-tax expense (like fire insurance or a consumer loan payment).
It Reduces Your Borrowing Ability: If your mortgage payment has PMI built in, by definition you have more debt, requiring more income to offset it. Without more income, the PMI erodes the existing income normally used to offset the rest of the mortgage payment and other obligations (like car payment, student loans, credit cards, etc). The exact amount of the PMI is how much your gross income is reduced by -- without the tax advantage. For example, a $250 per month PMI reduces your income by $250 per month.
Home Equity Needed: Here's the thing: You don't need to have 20 percent equity anymore to get rid of PMI. If an appraisal of the property you're going to buy shows you have 10 percent equity, you could qualify for the lender to pick up the monthly mortgage insurance payments, aptly called Lender Paid Mortgage Insurance. (This can also be done if you've already purchased the home and want to eliminate PMI from your monthly payment.) This is especially advantageous as PMI can be anywhere from 0.75 percent of the loan amount to 1.3 percent of the loan amount, annually, paid on a monthly basis. On a loan for $400,000 that could be as high as $430 per month, which is an immense net tangible benefit if the lender scoops up this premium each month.
However, you need an appraisal to see if you qualify for this. Most lenders' appraisal fee is $400 to $500, but it's worth it if you can get a substantially lower mortgage payment without the PMI. On the flip side, the appraisal may also determine that you have insufficient equity to qualify, but it will help you define exactly how much more value you would need to refinance in the future.
PMI Slows Your Mortgage Payoff Timeline: This is a big disadvantage of PMI. Let's say your mortgage payment is $2,800 per month, and $300 of it is the PMI payment. You're investing an extra $200 per month into your principal balance to reduce the interest you pay on the mortgage over time -- as a smart consumer, you're making a $3,000 per month mortgage payment. If you didn't have the PMI, you would be paying an extra $500 per month directly to your principal, compounding your timely prepay efforts and reducing your interest expense exponentially. If you're overpaying on your mortgage and you have PMI, you're only realizing half the potential you would be if you were able to get rid of the PMI or shift the cost of the PMI to the lender via lender paid mortgage insurance.
How to Cut PMI If You're Refinancing: Some homeowners have a mortgage they took out when 30-year mortgage rates were below 3.75 percent. In this case, why refinance a mortgage if you have a 3.25 percent 30-year fixed with PMI and a new 30-year fixed rate mortgage is just over 4 percent? Well, petitioning out with PMI is daunting task indeed, especially depending the type of loan you have.
If you have an FHA mortgage you took out pre-June 2014: The requirement then was after 60 months of mortgage insurance premiums paid to HUD and 20% equity, you had the ability to petition out of PMI - and it is up to the lender's sole discretion to grant the homeowner's request, not a guarantee. Alternatively, the PMI would be removed at 78 percent loan-to-value / 22 percent equity based on an amortization schedule from the original loan inception, calculating out at 120 months (that's 10 years).
However, PMI for FHA loans originated after June 2014 with 3.5 percent down contains permanent mortgage insurance, and the only way out is to refinance or with 10 percent down. You can petition out of the mortgage insurance after 10 years. However, refinancing may be a more worthwhile choice in either situation.
For conventional loans, you can petition to remove it after a minimum of 24 months of mortgage payments. The key here is: If refinancing into a conventional loan with lender paid mortgage insurance is less costly than how much more you would pay in PMI between now and when 24 months is up, moving out of the PMI would make sense as long as the rate is the same, or lower.
*Mortgage Tip: If the interest rate on a new refinance is 0.125 percent to 0.25 percent higher than the current rate with PMI, the rate differential could make financial sense if prepaying the mortgage.
Borrowers might just have more equity than they think. In many markets, home prices have not only stabilized, but have risen, creating more equity for homeowners who otherwise were thinly financed in years past. This additional equity can easily pave the path to reducing the PMI payment, if not completely removing it.
The Bottom Line: You can avoid PMI if you have as little as 10 percent down payment or home equity. Work closely with your loan officer, they are incentivized to help you. If you can't avoid mortgage insurance, depending on your financial situation, ask your lender what other adjustments can be made to reduce your mortgage costs: credit score, loan program and of course equity all play important roles in your loan structure. (You can check your credit scores for free every month on Credit.com.)
Scott Sheldon is a senior loan officer and consumer advocate based in Santa Rosa, California. His work has appeared in Yahoo! Homes, CNN Money, MarketWatch and The Wall Street Journal. Connect with him at Sonoma County Mortgages.