Laura answers a listener's question about whether to focus on eliminating mortgage PMI or paying down other debts first.
Laura answers a listener's question about whether to focus on eliminating mortgage PMI or paying down other debts first.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Emile, who says:
"I purchased a home several years ago and my payment includes private mortgage insurance (PMI). I also have other debts, including student loans and a small credit card balance. My income increased this year, so I have extra money to pay off my debt. Should I focus first on balances with the highest interest rates or pay my mortgage down so I can get rid of PMI?"
Thanks for your question, Emile! Knowing the best way to use your extra money is critical for taking control of your finances and getting out of debt. This post will explain what PMI is and how to know if getting rid of it should be your top financial priority.
Thanks for downloading episode 915 of the Money Girl podcast! I'm Laura Adams, an award-winning author, money speaker, on-camera spokesperson, and founder of The Money Stack, a Substack newsletter. You can subscribe for free or become a paid member with access to live educational events!
You can learn more and connect with me at LauraDAdams.com. That's also where you can email your money question, learn more about my books and courses, and sign up for The Money Stack. You can also record a brief question or comment on our voicemail line at 302-364-0308.
What is private mortgage insurance (PMI)?
When you get a conventional mortgage to buy a home or refinance an existing home loan and need to borrow over a certain threshold, lenders require you to purchase private mortgage insurance or PMI.
The amount you finance determines your loan-to-value (LTV) ratio. For example, if you borrow $270,000 to buy a condo valued at $300,000, you have a 90% ($270,000 / $300,000 = 0.90) LTV. Your downpayment would be the other 10% or $30,000.
When you can't put down at least 20% on a home and your LTV is higher than 80%, lenders consider you riskier than if you borrowed less. They mitigate that high LTV risk by requiring you to purchase PMI. It covers a portion of a lender's loss if you don't pay your mortgage and foreclosure proceeds are less than your outstanding loan balance.
While paying for an insurance policy that protects your lender is a bummer, the upside is that it makes buying a home with less cash upfront possible. Plus, you can eliminate PMI, which I'll discuss in a moment.
Note that FHA loans have different rules and may require you to pay mortgage insurance premiums (MIP), which differs from PMI. MIP can be more difficult to remove and often requires refinancing an FHA loan.
How much does private mortgage insurance (PMI) cost?
The cost of PMI depends on factors including your mortgage type, downpayment, credit, and property location. Lenders typically charge a premium ranging from 0.5% to 1.5% of your loan balance, which gets added to your monthly mortgage payment.
However, you may be able to pay a one-time PMI premium at closing. Or, you could pay an upfront lump-sum amount and monthly premiums. Lenders could charge you a higher interest rate instead of itemizing separate PMI charges.
Let's say you get a 30-year fixed-rate mortgage for $270,000 to buy a $300,000 condo. With a 90% LTV and average credit, your PMI could be about 1% or $2,700 per year or $225 monthly. It would be itemized on your mortgage statement so you could track when it gets eliminated, which I'll explain in a moment.
If you make a lump-sum PMI payment and decide to sell your home after just a few years or pay off your mortgage early, you don't get any portion of the premium back. So, paying monthly PMI is typically a better option.
Unlike mortgage interest, PMI is not tax-deductible. Therefore, paying a slightly higher interest rate instead of separate PMI payments could cost less after taxes. However, you can only claim the mortgage interest tax deduction if you itemize using Schedule A. When your total itemized deductions are less than the standard deduction for your tax filing status, you save money by claiming the standard instead.
To sum up, if your lender offers more than one way to pay PMI, get a detailed pricing comparison so you can consider the pros and cons of each option and which may cost less.
RELATED: Will renting or owning a home make you wealthier?
How do you eliminate private mortgage insurance (PMI)?
Now that you know why and how mortgage lenders require you to purchase PMI, it's important to understand the rules for eliminating it. The Homeowners Protection Act is a federal law with rules lenders must follow for canceling and terminating PMI.
You should receive an annual notice from your mortgage lender reminding you about your options to eliminate PMI under the following conditions.
The original home value can be the price you paid or its appraised value when you bought it, whichever is less. Your lender typically requires you to purchase an appraisal to verify that your home's value is the same or higher than when you brought it. Also, you must have a good payment history and no other liens on the property to qualify for a PMI cancellation.
Remember that if your home value appreciates significantly, you may qualify to cancel your PMI early. That's because when your home value increases, your LTV ratio goes down.
In addition, if you make extra payments that reduce your mortgage balance, your LTV also goes down. The sooner you reach the 80% LTV threshold, the sooner you can request a PMI cancellation! However, borrowing additional funds against your home, such as with a home equity loan or line of credit, increases your LTV, which may require you to pay PMI longer.
Should you pay a mortgage early to eliminate private mortgage insurance (PMI)?
Emile asked a great question about what to prioritize: paying down a mortgage to eliminate PMI or focusing on other debt when you have extra money. First, I recommend that Emile consider other essential financial goals, like investing for retirement and saving for emergencies.
If Emile doesn't have a healthy cash reserve or isn't regularly contributing at least 10% to 15% of gross income to a retirement account, such as an IRA or workplace 401(k), that should be a top priority.
Also, it's important to mention that if Emile has any dangerous debts, such as accounts in collections or credit cards with sky-high interest rates, they should be addressed first. As Emile mentioned, it's generally best to pay off debt in order of the highest to lowest
interest rate.
Assuming Emile's finances are in relatively good shape, how does paying PMI compare to a student loan and a small credit card balance? One way to answer this question is to pretend that your monthly PMI is an interest expense.
For example, if you borrowed $270,000 for a $300,000 home, you'd need an 80% LTV to request PMI cancellation. That means you'd have to pay down your mortgage to $240,000. Assuming you're near the beginning of a loan term, you'd need to pay about $30,000 ($270,000 - $240,000) to get there.
If you pay $225 a month or $2,700 a year for PMI, you could calculate it as a proxy for annual interest on a $30,000 loan. By dividing $2,700 by $30,000, you get 0.09 or 9%. Think of that as an amount you're currently paying in addition to your mortgage interest rate. If your mortgage costs 6.5%, you could pay more like 15% during the years you pay PMI.
However, this is an imperfect calculation because it doesn't account for the extra you pay toward your principal mortgage balance, how much equity builds as you prepay the loan, and any home price appreciation.
Also, the benefits of prepaying a mortgage to eliminate PMI decrease if you claim the mortgage interest deduction. For instance, a fixed-rate mortgage that costs 6.5% may only cost 5.5% after taxes, depending on your effective income tax rate.
Accelerating a mortgage to eliminate PMI may not help you as much as paying down high-interest debt, especially if your premium is relatively low. Plus, depending on price appreciation where you live and general housing inflation, you could be eligible for PMI cancellation sooner than you expect.
Another way to evaluate the interest rate you're paying for a mortgage with PMI is to add 50% to it. For instance, if your rate is 6.5%, consider that it actually costs you about 10% on balance. If your other debts cost more than these rough calculations, I recommend paying them down first, from highest to lowest interest rate.
However, if you have a small balance with a lower rate that you're anxious to eliminate, there's nothing wrong with that. Sometimes, it just feels great to wipe out a small debt!
READ ALSO: How to pay off credit card debt faster
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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