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The Legal Theft Called Private Mortgage Insurance (and How to Avoid It)

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When we bought our first home, we couldn’t afford the recommended 20% down payment. Heck, we could barely afford to bring $10,000 cash to the closing table.

Since this was our first time getting a mortgage, here’s all we knew about mortgages:

  • We needed one to be able to pay for the house and closing costs
  • The lower the interest rate, the better
  • We’d have to pay the lender each month for 30 years (or until we sold the house, whichever happened first) or we’d lose the house

What Is Private Mortgage Insurance

In the US, if you buy a home and take out a mortgage for more than 80% of the home’s appraised value, you’re legally required to buy something called Private Mortgage Insurance. PMI for short.

PMI works like this: each month, as part of your mortgage payment, you pay some extra to the PMI provider. In return, if you default on your mortgage, your lender will foreclose on your house and sell it to get as much as possible to pay off your loan. If the market dropped and the mortgage has a remaining balance after foreclosure, the lender will go to the PMI provider and have them pay off what you still owe. So far so good, right? This means your lender won’t go after you for money you don’t have. Here’s where it isn’t so good…

Once the PMI provider pays off your lender, they turn around and pursue you for what they just paid. Say what?! That’s like your auto insurance carrier paying off someone you hit, and then suing you for what they paid! Crazy!

The Cost of PMI

The cost of PMI varies a lot. Currently, according to NerdWallet, it’s between 0.55% and 2.25% of the original loan amount per year. This continues until you owe less than 80% of the home’s value and request that the PMI stop. The reduction in so-called loan-to-value (LTV) ratio can results from your home’s value going up (or it could actually get worse if the home value goes down). If the local real estate market is stable, your LTV will only decrease slowly as you gradually pay down the principal of the mortgage.

To see how much your PMI can cost you, let’s use the NerdWallet calculator with the following assumptions:

  • You’re buying a home that costs the median home value in the US, currently $226,800
  • You pay a 10% down payment of $22,680
  • You get a 3.75%-interest, 30-year-fixed mortgage to cover the rest of the home’s price
  • You pay each month the minimum required to pay off the mortgage in 30 years
  • The PMI is at the high end, at 2.25% of the original mortgage balance

Your monthly PMI payment will be $383. By the time you can remove the PMI, after about five and a half years, you will have paid a total of $25,470!

That’s over 5.3% of your total cost for buying the home, including mortgage principal, interest, taxes, PMI, and home-owners insurance! And that’s for something that protects your lender but doesn’t do anything for you! Isn’t that insane?

How to Avoid Paying PMI (Even if You Can’t Afford a 20% Down Payment)

Going back to when we bought our first home, we were lucky enough to work with a great lender. It was he who recommended that instead of getting a 95%-LTV mortgage, we get two mortgages. The first would cover 80% of the home’s value, and the second would cover what the first loan and our down payment didn’t cover.

The great thing with this scenario was that we didn’t take out a mortgage for more than 80% LTV. PMI isn’t required when your total LTV (or TLTV) is above 80%. Just if there’s a single loan with LTV above 80%.

A second mortgage may have interest rates about 1-2% higher than your first mortgage. That makes sense, because if you default, the lender of the second mortgage doesn’t get anything until the home is sold and the lender of the first mortgage is fully paid off. This means that the second loan’s lender is taking on higher risk, so they’ll charge higher interest.

The Cost of a Second Mortgage Is Much Lower than the Cost of PMI

As of this writing, you could get a Home Equity Line of Credit (HELOC) at 4.9%. You could use a HELOC as a sort of second mortgage. There are two drawbacks to this:

  • A HELOC typically give you a 10-year window to borrow, another 10-year window to pay off the loan, and a balloon payment at the end of 20 years to pay off any remaining balance. This means that you have 20 years rather than 30 to pay off this sort of second loan.
  • A HELOC’s interest rate typically varies from month to month, so you may end up paying a lot more over time if the interest-rate environment worsens.

Alternatively, you could get a fixed second loan. Let’s assume this can be done at a rate that’s 2% higher than that of current first mortgages. Using our assumption above that your first loan has a 3.75% rate, the second loan would come in at 5.75%.

The difference between taking out a 90% LTV first loan at 3.75% vs. a first loan at 80% LTV plus a second loan at 10% LTV (leaving the remaining 10% to be covered by your down payment) is $27.32/month based on the above assumptions.

If you keep the home for at least 30 years and never pay more than the required payments, the difference adds up to $9835.20. That’s more than 61% lower than the $25,470 you’d pay for the PMI.

Importantly, if you sell your house sometime after the LTV drops below 80% (say after six years), you will have paid the full $25,470 for the PMI, but only $1967 in excess interest for the higher-interest second mortgage. This would save you more than 92% of the PMI’s cost!

The Bottom Line

If you buy a home in the US and pay less than 20% down payment, you’re required to pay for Private Mortgage Insurance, or PMI. This can cost you more than 5% of the total cost of buying your home, including the cost of taxes and insurance, and this is spread out over the few years your loan-to-value ratio is above 80%.

The PMI you’re paying for pays off your lender if you default in the mortgage and the foreclosure doesn’t cover the remaining mortgage balance. This protects your lender, but does nothing for you, because the PMI provider will turn around after paying off the lender and pursue you for what they paid the lender.

In my mind, that makes PMI legally sanctioned theft – you pay tens of thousands of dollars for something that brings you no benefit, and that you could avoid by structuring your mortgage in a smarter way at a fraction of the cost.

Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.

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