||Ask Dr. Don
Dr. Don discusses how to
avoid private mortgage insurance, PMI alternatives, and paying PMI
Dear Dr. Don,
Will a 15 percent down payment on a home be sufficient
to avoid PMI or does it have to be 20 percent? My friends tell me
to avoid PMI, but other than 20 percent down they don't seem to
know how to avoid it. One lender told me I'd need 30 percent down
to avoid PMI. Is this common?
Twenty percent down is the standard hurdle to avoid Private Mortgage
Insurance (PMI). If you don't have 20 percent to put down on your
home, you can take out a second mortgage at the same time that you
take out the first mortgage. These financing plans are named by
the percentages attributable to the first mortgage, down payment
and second mortgage. In your case you could shop for an 80/15/5
However, there's a trade-off
between this approach and one where you take out a first mortgage
and pay the PMI premiums. A second mortgage will have a higher interest
rate than a first mortgage. The blended rate on the first and second
mortgages is likely to be more than the interest rate on an 85 percent
loan-to-value first mortgage. You also have to consider closing
costs on the second mortgage, and how a second mortgage's shorter
repayment terms impact your monthly budget. The interest expense
on the second mortgage will generate a tax deduction for most homeowners,
but the PMI premiums are not a tax-deductible expense. Work with
your lender or mortgage broker to determine which alternative is
less expensive on an after-tax basis.
If you aren't able to put
20 percent down, you have to choose between paying PMI until the
loan-to-value drops below 78 percent or taking out a second mortgage.
For homeowners with mortgages closing after July 29, 1999, lenders
are required to cancel your PMI when the loan balance falls below
78 percent of the purchase price. So, if you have 15 percent to
put down on a home, you'll have to pay down an additional 7 percent
to reach the point where the lender is required to cancel the insurance.
At 80 percent loan-to-value you can petition the lender to cancel
your PMI policy. See Daniel
Ray's article on the Homeowners Protection Act of 1998 for additional
information on canceling PMI.
One shortcoming of the act
is that it doesn't require lenders to consider your home's appreciation
when calculating when PMI must be canceled. Homeowners can use the
home's appreciated value to petition the lender to cancel PMI but
the lender doesn't have to accept the appraised value as justification
to cancel the insurance -- and you have to pay for the appraisal.
PMI cancellation provisions are something you should discuss with
your lender during the loan application process -- not at closing.
I am trying to avoid private mortgage insurance costs related
to buying a new house. Which is the best option in providing about
$40,000 to cover a 20 percent down payment?
- Borrow against my work
- Sell off securities and
take capital gains hit.
- Set up short-term line
of credit with a local bank and pay it off in five to 10 years.
There are a lot of ways to structure the purchase of your
home to avoid paying private mortgage insurance. The first mortgage
lender will require PMI if the mortgage is more than 80 percent
of the appraised value of the home. So to avoid PMI, you have to
raise enough cash outside the first mortgage to keep the loan-to-value
at or below 80 percent.
The most popular way to avoid
PMI is to take out a second mortgage at the same time that you take
out the first mortgage. The structure of the two loans can vary
but a common structure is 80-10-10. That means that there is a first
mortgage of 80 percent, a second mortgage of 10 percent and a cash
down payment of 10 percent. Many primary lenders also will lend
you the second mortgage, which streamlines the process. This approach
is better than a short-term line of credit because the interest
expense on a second mortgage will generate tax savings for most
Borrowing against your 401(k)
plan is an option, but for many people it derails their investing
for retirement because they stop making new contributions to the
plan while they are paying the loan. Changing employers also can
trigger a repayment provision, requiring you to pay off the loan.
You do pay yourself interest on the loan, but for most people that's
a lower return than they are averaging on their 401(k) investments.
Instead of selling your securities
in your taxable accounts, you could pledge them in lieu of a down
payment. A security pledge requires you to set up a separate account
and the assets have to be worth about twice the 20 percent down
payment. In your case you would need to pledge about $80,000 in
stocks and bonds. That gets the lender where they want to be on
a risk basis, and allows you to continue to realize the return on
those pledged securities. If the value of your investments fall,
you will be required to pledge additional securities. You can trade
the pledged stocks and bonds, but there are parameters on what securities
can be pledged. Tax-deferred investments such as those held in your
401(k) plan cannot be pledged. Brokerage firms that have a real
estate lending arm will be able to structure this mortgage loan
for you. Merrill Lynch does this type of mortgage lending. For a
good story on how this works, check out the this story: Use
stocks to finance your home
Which way should you go?
My last resort would be to borrow against the 401(k). Instead, have
a lender discuss an 80-10-10 or similarly structured loan with you
so you can get a sense of what the interest rate would be on the
second mortgage. Just don't get so wrapped up in the quest to avoid
paying PMI that you forget to consider the higher interest rate
and fees associated with the second mortgage. A primary mortgage
with PMI can be competitive and PMI doesn't last forever. And if
your taxable portfolio is large enough to consider pledging securities,
then talk with a brokerage firm about that product.
I purchased a home in January of 1988 for $94,000. I put down $10,000
and I'm still paying PMI. Should I still be paying PMI? Am I entitled
to a refund if I overpaid?
PMI, or private mortgage insurance, is an insurance policy that
the lender requires when the loan-to-value is greater than 80 percent
at closing. As an insurance policy, there's no real option to go
back in time and say the coverage wasn't needed so the premium should
be refunded. That said, if you are able to cancel the PMI policy,
you might be due a refund of up to a year's premium depending on
how your PMI payments were structured at closing and in the escrow
explains this refund in greater detail
12 years of payments and with almost 10 percent down initially,
it's virtually certain that you can cancel PMI. Two reasons why
the lender could reject your cancellation request would be past
payment problems or a declining home price. The Homeowners Protection
Act of 1998 requires lenders to notify homeowners annually about
the process of canceling PMI coverage. PMI cancellation on older
mortgages (closed before 7/29/99) isn't automatic under the Act.
can request cancellation when the loan-to-value reaches 80 percent.
On a 30-year mortgage, your loan-to-value calculation is closer
than you might think because lenders don't have to count your home's
price appreciation without an updated appraisal. Lenders use the
lower of appraised value or market price at closing to determine
when the loan-to-value reaches 80 percent. To see if your loan-to-value
is less than 80 percent, multiply the lower number by .80 and compare
that number to the loan balance. If your loan balance is below that
number, and you estimate that your home has appreciated in value
over the past 12 years, you shouldn't have to go through the added
hoop of getting an appraisal to cancel PMI coverage.
with FHA loans can check with HUD to see if they are owed an insurance
refund on their FHA insured loan. HUD has a fact
sheet that helps homeowners determine if they qualify for this
-- Posted: July 3, 2001