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Ask Dr. Don

Dr. Don discusses how to avoid private mortgage insurance, PMI alternatives, and paying PMI coverage.

Avoiding 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?
Barbara Bungalow

Dear Barbara,
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 mortgage.

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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.

Alternatives to PMI

Dear Dr. Don,
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?

  1. Borrow against my work 401(k) plan.
  2. Sell off securities and take capital gains hit.
  3. Set up short-term line of credit with a local bank and pay it off in five to 10 years.

Davis Downpayment

Dear Davis,
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 homeowners.

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.

PMI coverage

Dear Dr. Don,
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?
Sharon Stillpaying

Dear Sharon,
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 account. Pmirescue.com explains this refund in greater detail

After 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.

Homeowners 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.

Homeowners 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 refund.


-- Posted: July 3, 2001

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