With mortgage rates at historic lows, refinancing your mortgage could be a smart move. But determining whether a refi makes sense involves some math — and if you have to pay private mortgage insurance, or PMI, the math gets a bit trickier. Should you lock in low rates now, even if it means paying PMI? Or should you wait to refinance your mortgage until you have more equity and can avoid PMI, but risk getting stuck with a higher interest rate?
PMI payments might be less
To decide, you first need to know how much you’ll pay for PMI, which protects the lender in case you default. Hint: It’s probably not what you’re paying now. If your credit scores have improved or your home equity has increased — either because you’ve paid down your principal or home values have risen, or both — PMI might cost you substantially less than you’re paying now.
“So if you started out with 5 percent down, your PMI (with the current loan) would be more,” says Ilyce Glink, author of “100 Questions Every First-Time Home Buyer Should Ask.” “If you can refinance three years later and because your home has gone up in value, you now have 17 percent equity, PMI payments will be much less.”
PMI is typically required when you don’t have a 20 percent down payment or 20 percent equity in the property. Annual PMI premiums typically range from 0.3 percent to 1.5 percent of the amount borrowed. Other factors that influence what you pay, besides loan-to-value ratio and credit score, are loan size, the loan term and “coverage,” or how much of a loss the insurer will cover.
How coverage varies
You may need to know the PMI coverage percentage if you’re using one of the many available PMI calculators to estimate how much your monthly payment is likely to be. With 10 percent equity or less, PMI typically covers a loss to the lender of up to 30 percent of the loan balance. With equity closer to 20 percent, it’s 12 percent.
Another way to find out the cost is to simply ask a lender, Glink says.
Options for those with enough equity
If you have at least 10 percent equity in your home, you have other options to consider, such as:
- A second mortgage, either a home equity loan or home equity line of credit (HELOC), to avoid PMI (note that some lenders have temporarily stopped offering HELOCs due to the pandemic); or
- Lender-paid mortgage insurance, in which you pay a slightly higher interest rate in exchange for your lender paying the insurance in an upfront lump sum.
The interest on a home equity loan or HELOC is deductible if you use the money to buy, build or substantially improve your home, according to the IRS. The interest on lender-paid mortgage insurance is tax-deductible, but unlike regular mortgage insurance, lender-paid mortgage insurance doesn’t “fall off” or end when you have sufficient equity. You pay the higher interest rate until you sell or refinance.
So, should you refinance?
Once you know your various options, you still have to answer the question: Should you refinance?
With interest rates low, it may be worthwhile to refinance, especially if you locked in a much higher rate when you closed on your first mortgage. But the total costs of refinancing come down to more than just interest rate savings. You also have to consider new closing costs and the cost of PMI, if applicable. Keep in mind that Congress brought back the PMI tax deduction this year, which was previously available only through the 2017 tax year. Now, eligible borrowers can take the deduction for 2020 and beyond, as well as retroactively for the 2018 and 2019 tax years.
Mortgage expert Dick Lepre suggests you first calculate whether you can save money with a no-cost refinance — one that doesn’t require you to pay anything out of pocket. If you can’t save much, then you probably shouldn’t refinance.
If you could lower your payment, though, then you proceed to the next step, which is seeing how much you can save by paying closing costs yourself.
“If you get your money back in less than two years, then it’s a good deal,” Lepre says. “If it takes more than five years, it’s a bad deal. Anything in between is a coin toss.”
Featured image by The Washington Post of Getty Images.