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December 6, 1999
"We have a 5 percent
down payment and our lender has offered us a Tax Advantage Mortgage
Insurance plan instead of conventional private mortgage insurance (PMI).
Instead of paying a mortgage insurance premium, we pay a higher interest
rate. The lender says we come out ahead because the higher interest
payments are tax deductible. The rate on the Tax Advantage loan is 8.375
percent compared to 7.5 percent on the conventional loan. We are in the 28
percent tax bracket. Is this a deal for us?"
Virtually all lenders in the US
require PMI on mortgages with down payments less than 20
percent, but some will accept a higher interest rate in lieu of PMI. When
a borrower accepts this option, the lender buys PMI for less than the
borrower would have to pay. The higher interest rate covers the insurance
cost to the lender plus a profit margin.
The sales pitch for the higher
rate as a replacement for PMI is that interest is tax deductible whereas
PMI premiums are not. The other side of the coin, however, is that you
must pay the higher interest for the life of your mortgage, while mortgage
insurance will be terminated at some point.
This year, Congress mandated that
on most loans closed after July 29, 1999, mortgage insurance must be
cancelled at the borrower's request if the loan balance is paid down to 80
percent of the original property value. Further, insurance must be
terminated automatically when the balance reaches 78% of original value.
In addition, subject to certain conditions, PMI on loans sold by lenders
to the two Federal agencies (Fannie Mae and Freddie Mac) must be cancelled
when the loan balance reaches 80-% of the current property value,
taking account of appreciation.
There is no way you can figure in
your head whether the higher rate or PMI results in a lower cost. However,
the Pay
For Mortgage Insurance or Pay a Higher Interest Rate calculator on my
web site will do it for you. To crunch the numbers you'll have to give the
calculator relevant facts about you and your mortgage, including:
Tax
Bracket: Because of interest deductibility, the higher your tax
bracket, the greater the benefit of the
higher rate relative to PMI.
Life of Mortgage:
Because tax savings are highest in the early years, while mortgage
insurance premiums decline or disappear entirely at some point, the
relative advantage of the higher rate is greatest if you expect to be in
your house only a short time.
PMI Premium: The
higher the PMI premium, the more likely the higher
rate is a better deal. Premiums
vary with the type of loan, term, down payment and other factors.
The Rate Increment: The
smaller the increase in the interest rate charged in lieu of PMI, the
greater the advantage of the higher rate loan.
Mortgage
Insurance Termination: Early PMI cancellation makes the higher rate
option more expensive. Under
the most common PMI premium plan, the premium drops sharply after 10
years. Under recent Federal legislation, furthermore, lenders must cancel
insurance at the borrower's request when the ratio of loan balance to original
property value reaches 80%, and termination occurs automatically at
78%.
In addition, some borrowers can
have their insurance terminated when the balance falls to 80% of appreciated
value, which can result in termination much sooner. For example, assuming
5% down on a 7.5% 30-year loan and property appreciation of 1% a year, the
loan balance reaches 80% of value in 93 months; with 2% appreciation, the
target is reached in 67 months; and at 3%, in 52 months. The Pay
For Mortgage Insurance or Pay a Higher Interest Rate calculator allows
you to explore how these possibilities of early termination affect the
relative cost of the high-interest rate option.
In your case, I first assumed that
termination of PMI does not occur until the loan balance reaches 78% of
original property value. In that event, the higher interest rate loan
would be the better deal if you hold the mortgage less than 24 years. Then
I assumed that termination occurred when the balance reached 80% of
appreciated value, and that your house appreciated by 1% per year. This
was sufficient to reduce the cross over point to 13 years. With 2 percent
appreciation, it falls to 8 years, and at 3% to 6 years.
Bottom line: If you expect
significant appreciation and monitor your property value so you can
terminate PMI as soon as possible, the higher interest rate option is a
poor choice -- unless you expect to hold the mortgage a very short time.
Copyright
Jack Guttentag
2002
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