The Myth About PMI (It’s Not So Evil)

What I’m Drinking as I Write – Pour Over Coffee

I recently had someone ask me why anyone would put less than a 20% down payment on a house knowing they would have to make PMI payments until the 20% is reached. For starters, what is PMI? This stands for Private Mortgage Insurance, and it is insurance that protects the lender from the borrower defaulting (they don’t own much equity in the home at 5%). So, this insurance is a separate monthly payment that the homeowner has to make until they do have a 20% equity position in the home. Let me provide you with an example of how this might work.

You’re 25 and decide you’d like to buy a $150,000 home. You only have $10,000 cash that you are willing to spend on the down payment of this home, so let’s say you put exactly 5% or $7,500 down. In order to avoid PMI, one must put down a minimum 20% of the home value, or in this case, $30,000. You qualify for a 30-year mortgage with a 3.0% interest rate, and have a mortgage amount of $142,500 (home value of $150,000 – down payment of $7,500). Your monthly payment (including PMI) would be $918, with $74 for PMI. You will pay this PMI monthly until you have put 20% equity (principal only, not interest) into the home, which would happen approximately during year 9 in this example. After 9 years, you will have paid ~$8,000 in only PMI payments ($74 * 12 months * 9 years).

One other important thing to keep in mind is that a homeowner that puts at least 20% down will not require as large a loan size – in this example the homeowner that puts $30,000 down will only require a mortgage of $120,000 vs. $142,500 for 5%. Besides PMI, this will save the homeowner money towards regular interest payments as well. A homeowner that puts down 20% will pay $297/month in interest vs. $353/month at 5% down. Over 30 years, that’s a difference of $11,632 (excluding PMI). Including the $8,000 that would have been saved from PMI payments, that’s a total of $20,000 that has been saved over the life of the loan.

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So, why would anyone with the capability of putting down 20% on a house only put down the minimum 5%?

Using the same example from above, you think you’d rather put the minimum 5% down on a house because borrowing rates are so low and you’d like to take advantage of them. So, you put $7,500 down on the house and invest the remaining $22,500 (the difference between the 20% and 5% down payments). You invest in SPY, a S&P 500 index fund, which you expect to earn 8% annually over the next 30 years. At the end of the 30 years, the original $22,500 is expected to be ~$226,410, for a gain of approximately $203,910. You gladly paid the extra $8,000 in PMI payments for the first 9 years (after 9 years your investment has an unrealized gain of $22,480, or $14,480 after the PMI payments). After taking the additional total interest and PMI payments over the life of the loan out of your realized gain of $203,910, you are left with nearly $184,000 earned over 30 years. That sounds a lot better than putting down 20%.

So what’s the catch? Why doesn’t everyone put down the minimum 5% instead of 20%? Ironically enough, it’s most likely because they can’t afford to – monetarily or emotionally. Homeowners would rather save the $130/month to put towards groceries, utilities, additional mortgage payments, etc. And in all honesty, who is actually going to invest the difference between the 5% and 20%? Assuming someone does, will they set that money aside and have enough self-discipline not to touch it before the 30 years is up? Rather, will they get greedy and cash out when the market hits new highs, or fearful and cash out when the market is at all-time lows? 

As with all things, there are several factors that should be taken into consideration that have helped to validate my argument:

• What are current interest rates? If this were 1981 when the annual average for mortgage rates was 16.63%, that would change a few factors and would most likely change my advice. 
• How willing or able are you to invest that amount of money with no need to touch it for the next 30 years?
  • Do you have an annual income that will support a healthy savings account?
  • Do you have enough saved for closing costs, home repairs, or renovations?
  • Will you live paycheck to paycheck and need that $130/monthly savings for food and other necessities? 
• What would you invest in? Do you feel comfortable about the amount of return vs. risk over the next 30 years?

My advice? Go big or go home. Do the minimum and put 5% down, invest the difference, and reap the benefits. Or, put the 20% down, avoid the PMI and additional interest charges, and enjoy a little extra savings each month. Everyone is different. Some choose to spend their money now and save less for later, and vice versa, so do what makes the most amount of sense for your situation.

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Lesson:

I recently purchased a car and put a considerable amount down in order to have a lower borrowing rate and lower monthly cost. Did I know that I could put a very small amount down, take out a larger-sized loan, and pay a little extra each month and do something else with this money instead? Of course I knew; yet, I hadn’t done it so what would change now? The cash I spent on the down payment had previously just been sitting in my savings account, earning next to nothing (I was actually losing money if we’re considering inflationary impact). The thought of having a loan that large scared me when I knew I had the cash just readily available in my account, so what was the point in taking out unnecessary money? So I used the money that had been collecting dust to put down towards my car and the lower loan combined with a lower rate cut my monthly payment by $50. I have now set up an additional automatic monthly contribution to one of my investment accounts in the amount of $50. Over the course of 48 months (the life of the loan), based on an 8% annual return I would earn approximately ~$2,836 ($436 in interest, the rest in my monthly deposits). This is nothing. However, this taught me a lesson. Could I go back and change the fact that I put a large down payment on my car? No. Did I realize I should start putting all my excess cash to use (like I should have been doing in the first place) rather than holding onto it to feel better and “safe”? Yes. I opened another retirement account. I set up automatic bi-weekly contributions from my savings account directly into a retirement account and an individual brokerage account. I am now putting my dollars to use by investing small amounts over time on an automatic schedule.

So many things seem like common sense in theory, then seem so different or impractical in practice. And sometimes you have to learn a few lessons before seeing the theory play out right in front of your eyes. Build a healthy savings account and/or emergency fund, but after you’ve reached your target amount, don’t just let the excess dollars remain in cash. Remember, you are earning a negative real return in cash (your savings account interest rate is probably 0.5% at the most and current inflation is 5%, while historical average inflation is ~3%). I encourage you to set up automatic contributions to your investment or retirement accounts. Set reminders for yourself to check your savings account occasionally to make sure your cash balance isn’t egregious. Start investing excess cash now, because the longer you wait, the more you will have to catch up later.

Happy Sipping,

E