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The Truth About PMI

The Truth About PMI

P...M...I... Three letters which become very important for anybody looking to buy or refinance a home. An acronym for private mortgage insurance, PMI is needed whenever you have less than 20% equity or cash down payment for a new first mortgage. Ask anyone you know about it, and they'll most likely advise you to avoid PMI at all costs. This is often referred to as common financial wisdom. What you're about to learn, however, is that common wisdom isn't always common, or correct. In some cases, choosing a mortgage with PMI actually makes sense.

PMI is nothing more than insurance that will cover the lender in the event the borrower falls into default, causing the lender to foreclose. PMI does not benefit the borrower directly other than helping many buyers to qualify for a mortgage and finance their home.

It is important to know that PMI isn't always required if you don't have the funds available to reach that 20%. A skilled mortgage professional will advise you that avoiding PMI can be accomplished by taking out a second mortgage for the amount needed to close. In other words, if you were purchasing a home for $250,000 and only had $25,000 available for your down payment, you could choose to take a first mortgage in the amount of $200,000 and a second mortgage in the amount of $25,000.

The second mortgage could be in the form a home equity line of credit or a traditional second mortgage. The traditional second mortgage would be a loan for a specified term of five to thirty years. In most cases, it would be a term of fifteen years.

There are advantages and disadvantages to each of these second loan options. The primary benefit of choosing a Home Equity Line of Credit, or HELOC, is the payment. Most HELOCs are set up with the option of making an interest-only payment, allowing for greater monthly cash flow. There are, however, two disadvantages to a HELOC. The first is that they are subject to monthly adjustments tied to the Prime Interest Rate, which has been increasing steadily. The second is, unless you make a payment above the required amount, your balance owed will remain unchanged so you won't be making progress on your debt.

Second mortgages that come with a fixed interest rate and term offer the benefit of a locked interest rate and payments which are applied toward interest and principal, decreasing the amount owed with each payment. The disadvantage to this kind of mortgage is that the minimum payment is higher than it would be with a HELOC.

Here are three examples of how to finance a home valued at $250,000. They will show you the differences between financing 90% of the value with PMI, a HELOC, and a traditional second mortgage. Please note that the interest rates presented here are for illustration purposes and may not be in effect at the time you actually apply.

One other thing to consider when choosing a mortgage is the amount of time you will actually have the mortgage in place. As interest rates fluctuate and as situations in life also change, people rarely have a mortgage in place for thirty years. We will look at what the total costs would be if your financing were in place for five years.

PMI
HELOC
Closed End
Second
First Mortgage Amount
$225,000
$200,000
$200,000
Interest Rate
7.00%
7.00%
7.00%
Term (Months)
360
360
360
Payment (P&I)
$1,497
$1,330
$1,330
Mortgage Insurance
$98
Second Mortgage Amount
$25,000
$25,000
Interest Rate
9.50%
8.80%
Term (Months)
Interest Only
180
Payment (P&I)
$198
$251
Total Payment
$1,594
$1,529
$1,581

If your home appreciates at a rate of 5.00% per year, you will be in position to have PMI removed from your mortgage after the second year. There is now enough equity in your home to cover the lender in case of foreclosure. If you had your PMI cancelled at this point, your mortgage payment would be reduced by $98. Regardless of what happens with your home's value, if you'd chosen either of the second mortgage options your payments would not change. This also assumes no change in interest rates in the case of a HELOC.

If you take into consideration the total payments made, the amount of principal paid, and your remaining balance at the end of the five year period, the least expensive choice is a closed end second mortgage. The most expensive option is a HELOC, even though your monthly payment is less.

The reason for this is your total amount owed at the end of the five years is $1,467 more based on the HELOC payment being interest only. If interest rates rise from where they are today, this option becomes even more expensive.

There are several things to take into consideration when financing your home. It's advisable to speak with a mortgage professional who can show you the different options available based on the time you expect to live in the home or have your mortgage in place.

These examples are for a home purchase, but the same principals apply if you are looking to restructure your finances. Interest rates have risen dramatically in the past few years for HELOCs, credit cards, and student loans. Contact your mortgage professional today and ask for a total analysis to determine if consolidating your debt into a new first mortgage makes sense. In many cases, this will be true even if the interest rate on a new first mortgage is higher than the one you currently have.

Your mortgage professional can show you the blended interest rate you are paying for all your debt, both mortgage and consumer, and determine the best course of action for you. However, don't wait! Call today because interest rates are on the rise.


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