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Should You Avoid Private Mortgage Insurance?
The majority of home buyers would avoid paying for private mortgage insurance (PMI) if that option is open.
PMI is basically a requirement when a property buyer borrowers more than 80% loan-to-value.
This is deemed necessary as the lender would be taking more risk associated with the home loan and wants to be protected by insurers for that added risk.
This is why private mortgage insurance actually only insures the upper 20% of the loan against a borrower’s default.
For example, if $100,000 is owed to the bank, and the house is sold by the bank for $90,000, then the insurer would top up that remaining 10%. And if the sales proceeds is $70,000, the insurer would cover only $20,000 as 20% is the limit of such policies.
It is easy to see why borrowers have a negative perception towards buying PMI policies. It’s not to their benefit, but to the bank’s…
Or is it…
While paying for insurance to protect the lender can seem repulsive to many, there are various instances when PMI can actually help homeowners save money.
Firstly, consider that PMI brings the big benefit (which home buyers often don’t mention) of allowing home buyers who don’t have 20% as down payment to finance the purchase.
In the past, this single factor alone would be enough to deny many a home buyer from buying his own house.
From this point of view, PMI has actually done a lot of good for society by enabling home ownership.
In the absence of mortgage insurance, a buyer could be able to borrower up to 80% LTV. But with PMI, he can effectively borrower much more than that.
This makes cash much less of an issue and turns the attention of affordability to cash flow, which can be the key for many households in financing their purchases.
And even though the closing costs might increase for a home buyer who has taken up PMI, the way these things are structured can actually mean more savings when you consider the other options available as alternatives to PMI.
A common way for home buyers to side-step the requirement of PMI is to get the lender to approve a higher loan quantum anyway. This is actually possible.
But the bank would of course charge higher interest rates over the life of the loan to balance up their risks.
They would then purchase PMI on behalf of the home buyer at wholesale price, then allow the extra interest charges to offset that cost… and bank in additional profits over the entire life of the mortgage.
From a long term perspective, this is actually a detrimental situation for the buyer.
In addition to that, both interest and PMI are tax deductible. If’s not as if one is better off than the other.
A big reason why borrower might choose to go with a bigger bulkier loan from a lender than get PMI could be that they think PMI premiums would last for the life of the loan.
This is no true.
Because as soon as the loan value goes below 78% of the property value, PMI can be removed. And this can easily be trigger by real estate with booming price trends.
In explosive real estate markets, you might just need to wait 3 years (or even less) to have appreciation make PMI irrelevant.
A bigger loan upfront would also allow you to use your personal funds to make improvements to the property to increase value instead of letting go into the down payment.
Get the property value appraised and make your case to the lender.
Another way to navigate around private mortgage insurance that is commonly practiced is to get a first mortgage at 80% LTV, then a second mortgage at 10% or 15%.
These are also called piggyback mortgages.
These types of loans would only be advantageous in some circumstances.
Take note that PMI can be removed usually in a few years due to the appreciation nature of most real estate. But a second mortgage can only be removed… by paying it off in full!
So if savings is one of the focal points in decision making, getting PMI can easily seem like the best option over the long term.
Or if you are dealing with a desperate seller, consider trying to get him to make a one-time PMI payment for you.
He might just do it.
When we have discussed above is from the perspective of the regular home owner.
What about real estate investors?
For investors, PMI allow a higher loan to value, which effectively enables higher leverage. Leading to less capital and higher ROI.
It also frees up funds for acquisitions of more properties.
So investors are often the biggest advocates of PMI.
But remember. You have to make this decision yourself after contemplating your whole financial situation.
Don’t purchase or avoid PMI by following the trend.
That is a recipe for disaster.