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Avoiding private mortgage insurance

Dear Dr. Don,
We are trying to decide between a 25-year bank mortgage (with no PMI with 90 percent loan-to-value and no escrow) with a rate of 7.39 percent, and a traditional 30-year mortgage with a 7-percent interest rate and PMI and escrow.

The loan will be for about $140,000. We will probably stay in the home for 10 years. I have looked at the cost per month, the probable tax savings and the equity at five years. Which would cost more over years five to 10, the higher interest rate or the PMI? Can you offer some advice on this?
Wendi

Dear Wendi,
This is a pretty complex analysis to do on an apples-to-apples basis. The bank loan's higher interest rate and shorter loan term make for a larger monthly payment even after considering the private mortgage insurance payment on the traditional loan.

The best way to evaluate your two options is to put them on an equal cash-flow basis. The 25-year loan has a monthly payment of $1,024.59. The 30-year loan's monthly payment is $931.42. The PMI on that loan is estimated to be $60.67. So, to put it on an equal cash-flow basis, you should plan to contribute an additional $32.50 each month in additional principal payments for a total monthly payment of $1,024.59.

Don't worry about whether you're required to escrow the taxes and insurance. Ideally, your escrow payments will match your annual expenses for taxes and insurance, so it's more a matter of household budgeting than a difference to consider between the two financing methods.

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PMI doesn't last forever -- it just feels that way. Under the Homeowner's Protection Act of 1998, mortgages that closed on or after July 29, 1999 will have their PMI policies automatically canceled when the loan balance falls to 78 percent of the original purchase price/appraised value.

For the traditional mortgage, including the additional principal payments, PMI would be cancel after approximately eight years. Again, to keep the analysis on an equal cash-flow basis, I assumed that the amount you were paying in PMI premiums went to additional principal payments in years nine and 10.

The additional interest expense associated with the 7.39-percent mortgage will generate additional tax savings if you can use the deduction on your income taxes. A quick and dirty way to estimate the value of the lost tax savings is to multiply the difference in interest expense by your marginal federal income tax rate. As shown in the table below, by using a 28-percent marginal federal tax rate, I estimate the lost tax savings as $1,161.

25-year bank mortgage vs. 30-year traditional mortgage

 

25-year, no PMI

30-year with PMI and extra payments

Loan amount

$140,000

$140,000

Loan term

25

25

Interest rate

7.39%

7.00%

Monthly payment

$1,024.59

$931.42

Additional principal payment
(months 1-96)

-

$32.50

Estimated PMI

-

$60.67

Additional principal payment
(months 97 on)

-

$93.17

Total monthly payment

$1,024.59

$1,024.59

After 10 Years:

 

25-year, no PMI

30-year with PMI and extra payments

Total mortgage payments
$122,950.97
$111,770.82

Total monthly PMI*

-

$5,824.32

Total additional principal payment

-

$5,356.08

Total payments

 $122,950.97

$122,951.22

Total interest

 $94,226.16

$90,080.91

Loan balance

 $111,275.20

112,954.00

*assumes PMI canceled after eight years.

Difference in loan balances
 -
$1,678.80

Additional interest expense

$4,145.25

 -

Marginal federal income tax %

28%

 

Lost tax savings

$1,160.67

 

By putting the two alternatives on an equal cash-flow basis, you can see where you stand at the end of the 10-year period and use that as the basis for your decision. In this case, your loan balance is $1,678 higher, and you've lost $1,160 in tax savings if you decide to use the traditional mortgage with eight years of PMI payments. So, over a 10-year horizon, the bank mortgage looks better.

Another way to look at this is to look at the average additional expense associated with the higher interest rate and compare that with the average additional expense associated with the PMI premium. Again, over a 10-year horizon, the bank mortgage looks better.

Additional expenses compared
Average loan balance (years 1-10)

$140,000.00

Additional interest on 25-year loan

0.39%

Average annual difference in interest expense on 25-year loan

$490

Average monthly difference in interest expense on 25-year loan

$40.83

Average monthly difference in interest expense on 25-year loan -- (after-tax basis, assuming 28%)

$29.40

Average monthly PMI on 30-year loan (spread over 10 years)

$48.54

Monthly savings on 25-year loan

$19.14

 

 

Another thing to consider is the difference in closing costs between the two loans. If the traditional 30-year mortgage has lower closing costs, then those savings can cause you to change the analysis.

Roughly speaking, if the traditional mortgage has closing costs that are $800 less than the bank loan and you used that money to pay down the mortgage, that would eliminate the difference between the loan balances at year 10, although the bank loan would still have the additional tax deduction for the higher interest expense.

-- Posted: Feb. 20, 2002

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See Also
The basics of private mortgage insurance
More Dr. Don stories

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