Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

PMI issues

Dear Dr. Don,
I was advised that I should choose a higher rate without PMI rather than a lower rate with PMI because I will have a greater deduction at tax time. Is this valid?
Chip Choices

Dear Chip,
Private mortgage insurance (PMI) protects the lender against losses if your home is sold in foreclosure. That's why it's not required when you make a substantial down payment.

If the home is sold in foreclosure, you lose some or all of your equity while the loan should be paid in full.

A lender can price foreclosure risk into the interest rate, which is called a self-insured mortgage. The higher interest rate isn't per se PMI, so if you can use the mortgage-interest deduction on your taxes then you are able to fully deduct the mortgage-interest expense.

The higher interest rate compensates the lender for the additional risk associated with a low down payment mortgage. In some cases, the interest rate will roll down to a lower rate after the loan has been paid down to 80 percent of the initial loan amount.

Private mortgage insurance is not, in itself, a tax-deductible expense. You can finance the PMI expense and that will increase your mortgage interest deduction, but only by the amount of the insurance premium. IRS Publication 530, Tax Information for First-Time Homeowners, details what you can and cannot deduct.

If you have enough in savings or investments for a down payment that will qualify you for a mortgage without mandatory private mortgage insurance, then you shouldn't consider making a smaller down payment to get a higher interest rate and pay PMI.

But does it make sense to use a self-insured mortgage instead? The table below compares a no-PMI mortgage to a self-insured mortgage and a mortgage with monthly PMI payments.

	No PMI	Self insured No PMI	Mo. premium PMI
Purchase price	$225,000	$225,000	$225,000
Down payment %	20%	10%	10%
Down payment	$45,000	$22,500	$22,500
Mortgage term	30 Yr. Fixed	30 Yr. Fixed	30 Yr. Fixed
Interest rate	6.100%	6.650%	6.150%
Loan amount	$180,000	$202,500	$202,500
Loan payment (1)	$1,090.79	$1,299.98	$1,233.69
PMI payment (2)	$-	$-	$87.75
Total monthly payment	$1,090.79	$1,299.98	$1,321.44
Total interest	$212,685	$251,208	$241,627
Total PMI	$-	$-	$        8,424
Total interest & PMI	$212,685	$251,208	$250,051
Difference		$38,523	$(1,157)
(1) Self-insured analysis assumes interest rate is rolled down to 6.15% after eight       years.  New monthly payment is $1245.87.
(2) Monthly premium PMI assumes PMI policy is canceled after eight years.

Your situation will be different, but expect the self-insured mortgage to have a higher interest rate by about half of a percentage point.

In the example, I've assumed that the lender will roll back the interest rate once the loan balance reaches 80 percent of the home's initial value. Not all self-insured loan programs will offer this feature. If you can find one that does, it will save you the cost of refinancing to get out from under the higher interest rate.

While it's true that you don't put as much money down with the self-insured and PMI options and that may allow you to invest the $22,500 difference for 30 years, it's also true that you have the ability to invest the monthly savings from the No PMI option. I'm calling this a wash even though, if you had the discipline to invest the monthly savings over the 30-year loan term, investing the monthly savings would beat out investing the $22,500 as a lump sum.

The tax deduction on the self-insured option is worth about the sum of your combined federal, state and local tax rates times the difference between the total interest expenses. In this example, the difference in the total interest expense between the self-insured option and the No PMI option is $38,523. If your combined tax rate is 35 percent, then that lost tax deduction is worth $13,483 spread out over the life of the loan. It doesn't make any sense to spend $38,523 to save $13,483.

The choice between the PMI and the self-insured options is a little closer. In this example, the difference in interest expense is $9,580 making the value of the tax deduction (at 35 percent) on the extra interest expense $3,353 over the life of the loan, while the cost of the mortgage insurance premium is $8,424. Since the difference in total interest and PMI is only $1,157, the additional tax deduction gives the self-insured mortgage the edge over paying PMI.

As you can see, the difference between the two options is close enough that the assumptions concerning when the PMI policy will be canceled, and whether the interest rate will be reduced on the self-insured mortgage are critical in determining which mortgage is the better choice. When you're shopping loans, have your lender or mortgage broker compare your alternatives and help you decide which loan is appropriate for your situation.

-- Posted: Nov. 30, 2001