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Hi, everyone. I’m Laura Adams. Your host, a personal finance author, speaker and consumer advocate who’s been producing this show since 2008.
My mission for Money Girl is to give you the knowledge, resources, and motivation to manage your money the best way possible and create a richer life. New episodes are released every Wednesday, and when you’re subscribed to the show, they automatically show up in your podcast app. It’s like magic. So be sure to hit that subscribe button in the Apple podcast app or wherever you listen. Today’s show is courtesy of an email I received from Danielle M. She says I’ve been listening to your podcast for about five years now since I graduated from college.
I greatly appreciate the tips and guidance that you give to the community as a whole. Thank you for giving me the confidence and knowledge to build a solid financial foundation. I recently purchased a home that includes a PMI payment. I also have student loans and a small car loan. We have extra money every month to put toward our loans. I understand that it’s best to pay debt down in order of the highest interest rate to the lowest interest rate. I’m wondering how to evaluate my mortgage since the interest rate doesn’t include the PMI payments.
Should I pay down my mortgage until the PMI is gone or is it better to focus on my higher rate student loans first? Danielle this is a really great question and it can be confusing because, you know, knowing where to put your extra money every month is so important. And your PMI is something that’s kind of like tacked on to your mortgage payment. So in this podcast, I’m going to explain what PMI is, the rules for getting rid of it and how to know when it should be your top financial priority.
And at the end of the show, I’ll also answer a question that recently came in from Christy M., who is trying to figure out something kind of similar. She’s gotten a windfall and is trying to understand what to do with that money. So we’ll touch on that as well. So this show is for you. If you’re a homeowner, you’ve got a mortgage or maybe you want to be a homeowner one day. Buying a home is a huge financial step.
It’s probably the biggest debt and financial responsibility that you’ll ever have. So understanding it fully, it’s pretty critical for protecting your financial future. As always, you’ll find the notes for this show and the complete archive of podcasts in the Money Girls section at Quick and Dirty Tips dot com. This is episode number 627. Should you pay down PMI or high-interest debt first? Let’s talk about what exactly PMI is. It stands for private mortgage insurance. And if you take out a mortgage, you’re probably pretty familiar with this.
If you’re looking to buy a home or even to refinance an existing home loan, the last thing that you want to hear is that you’ve got to pay an additional charge. And this is called private mortgage insurance. You might even feel worse when you find out that this insurance doesn’t protect you. It protects the lender. Borrowers have to shell out for PMI when they get a conventional mortgage, but can’t put down at least 20 percent. So the amount you borrow to buy a home that’s called your loan to value ratio or LTV kind of mortgage jargon.
For example, if you let’s say you borrow one hundred and eighty thousand dollars to buy a home that’s valued at two hundred thousand. You have a 90 percent LTV. You figure that by getting the amount that you borrow one hundred and eighty and dividing it by two hundred thousand. When your LTV on a home mortgage is higher than 80 percent. Lenders consider you to be a bigger risk than if you borrowed less. So the lender is going to mitigate that risk by requiring you to purchase PMI.
The policy would cover a portion of their loss if you didn’t pay your mortgage and they foreclosed on your property and those proceeds didn’t cover your outstanding loan balance. However, I will say there’s a bright side to paying PMI. It does make it possible for many borrowers who can’t afford to put down 20 percent on a home to buy a home, and PMI can be eliminated at certain LTV thresholds that were going to cover. So you might be wondering how much just PMI typically cost?
Well, it does vary depending on a few factors. These include the type of mortgage that you get, how much you put down, where the property is located, your credit, your loan term and even how lenders structure your PMI fee. In general, there are three ways that lenders charge PMI. The first is the most common and these are monthly payments. So these are going to get added to your monthly mortgage payment. The premium could range from point 2 percent, maybe up to 1.5 percent, maybe 2 percent of the balance on your loan each year.
The annual cost is typically divided into twelve premiums and added to your monthly mortgage payment. So that’s the most common way that you’re charged PMI. There are other ways, though. The second way that a lender can charge it is with a lump sum payment. This is a one-time premium that you pay upfront at closing. Now you may also have a combination of a lump-sum payment and monthly premiums in some cases. And a third way that lenders can charge PMI is simply by charging a higher interest rate.
In some cases, a lender may just give you a higher rate instead of itemizing a separate PMI charge. So there’s a lot of variabilities there. And monthly payments, as I mentioned, are the most common way. So let’s say that you get a 30 year fixed rate mortgage for one hundred and eighty thousand dollars to buy a home valued at two hundred thousand with a 90 percent LTV and good credit. Your PMI could cost you about $100 per month, so paying monthly PMI gives you the most transparency about the charge.
It gets itemized on your mortgage statements, so you know exactly how much you’re paying. And more importantly, you can see when it finally gets eliminated, which we’re going to talk about next. But if you make a lump sum PMI payment, it could turn out to cost more or even less than the other options, depending on whether you choose to pay off your mortgage ahead of schedule or not. It depends on maybe if you saw your home after just a few years or pay off your mortgage early.
You don’t get a return of any PMI premium. So remember that if you’re thinking about owning a home just in the short term, doing a lump sum upfront, PMI payment may not be the best choice. And since mortgage interest is tax-deductible, the option to pay a higher interest rate instead of a separate PMI payment could cost less on an after-tax basis. Also, PMI is currently a tax-deductible expense, although there have been periods when it wasn’t.
But at the end of the year, lenders will send out a form called form 1098. And it’s going to list out how much PMI and how much mortgage interest you paid during the year so that you can claim it on your tax return. And for 2020, PMI is a tax-deductible expense. However, you can only claim these deductions if you itemize them using schedule A on your tax return when your total itemized deductions are less than the standard deduction for your tax filing status.
You’re going to save money claiming the standard deduction instead. So, you know, this is a whole another whole issue here is whether you even itemize in the first place if you can. You can definitely add PMI mortgage interest to those deductions and that makes the after-tax cost of your mortgage even lower. So as you can see, there’s a lot going on here. And knowing which option is best for paying PMI can be a bit complicated. If your lender offers more than one way to pay it, ask for a detailed pricing comparison so you can weigh the pros and cons and consider which option may be less.
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OK, now that you understand a little bit more about PMI, what it is, the different ways that a lender can charge you for it. Let’s talk about the rules for getting rid of it. That’s going to help, you know, how high a priority it should be when you’re looking at your overall financial situation. So you should receive an annual notice from your mortgage lender that reminds you about your options to have PMI eliminated under certain conditions. And here are the ways that you can get rid of it.
And again, this is for monthly ongoing PMI payments. If you paid a lump sum payment that’s done, you can’t get that back. But for ongoing payments, typically you can request cancellation of it after you pay down your mortgage balance to 80 percent of the original value of your home. And the original value can be either the price that you paid for your home or its appraised value when you bought it or maybe when you refinanced it. Whichever is less, your lender will require you to get a property appraisal to verify that your home’s value is the same or even higher than when you first purchased it.
The appraisal fee could range from three hundred dollars, maybe even up to a thousand dollars, depending on the size and the location of your home. All right. So that’s the first way to get rid of PMI. You’re going to request the cancellation after you get to an 80 percent LTV. The second way you can get rid of PMI is called automatic termination. This should happen when your mortgage balance reaches 78 percent of the original value of the property.
PMI at that point is supposed to be canceled. In this case, you don’t have to requested and you don’t have to pay for the appraisal, but you do want to watch and make sure that your lender is terminating it at the right time. And the third way that you can get rid of PMI is called midpoint termination. This happens when your mortgage balance reaches its midpoint. PMI is supposed to automatically be canceled. Then, for example, let’s say you’ve got a 30-year mortgage.
Your lender must cancel your PMI after you’ve paid your mortgage for 15 years. That’s the midpoint. But what’s important to know here is that there are situations that might allow you to cancel PMI early, such as if your home value appreciates due to market conditions. When your home value goes up, it lowers your LTV. Likewise, if you make additional mortgage payments that reduce your principal loan balance. That also lowers your LTV. So you really need to be watching this as a homeowner.
And don’t just assume that your lender knows what’s best. You know what’s going on in your market. You know, if your home value is appreciating and that’s going to allow you to get rid of PMI even faster. Also, be aware that your lender can deny your request for PMI cancellation in certain situations, such as if you’ve made late payments. You do have to get current on any outstanding payments in order to have PMI canceled either as a request or automatically.
Also, don’t forget that taking out a home equity loan or a line of credit would increase your LTV. All right. Now that you know a little bit more about when you have to pay PMI when you can eliminate it, let’s turn back to Danielle’s question. She’s considering whether to spend extra money to her mortgage and to get closer to canceling PMI or if it’s better to use her money to pay off her student loan or her car loan faster.
First, I’m going to recommend that Danielle kind of zoom out and look at her overall financial situation and look at any other top financial priorities that maybe something she’s overlooking. She didn’t mention if she’s regularly contributing to a retirement account or if she has any savings if she does not have a healthy emergency fund or she isn’t investing a minimum of 10 to 15 percent of her gross income for retirement. That’s where I would want her to put her extra money first.
We know that Danielle doesn’t have any dangerous debts like accounts and collections, credit cards with sky high-interest rates or any expensive payday loans. If she did, those would definitely need attention before addressing any other type of debt. But as she mentioned in her question, it is generally best to pay off your debt in order of highest to the lowest interest rate. So assuming that Daniel’s finances are in good shape, how does pay PMI to compare with a student loan and a small auto loan balance while ongoing PMI payments are not an interest expense?
You can kind of pretend that they are as a technique for. Understanding their place in your financial life. So let’s say that you borrowed $180000 for a $200000 home, giving you a 90 percent LTV so you would have to pay down your mortgage to one hundred fifty-six thousand dollars to get there. Now, if you’re at the beginning of a loan term, you’re going to need to shell out $24000. That’s $180000 loan balance minus one hundred and fifty-six thousand, which is where you need to be for cancellation.
The difference, there’s $24000. If you were paying $100 a month or that’s twelve hundred dollars a year for PMI, you could calculate it as a proxy for annual interest on a $24000 loan that comes out to an effective interest rate of about 5 percent. You take twelve hundred dollars a year in PMI divided by the amount that you need to pay $24000. That comes out to about 5 percent. That’s an amount that you’re paying on top of your mortgage interest rate.
So if your mortgage cost about 4 percent in this example, you’d really be paying more like 9 percent during the years that you pay PMI. However, this is a very imperfect calculation because it doesn’t account for a whole lot of factors. It doesn’t account for how much extra you pay toward your principal mortgage balance, how quickly equity builds as you prepay it in any home appreciation. So there’s a lot of other variables there. Also, the benefits of accelerating your mortgage payments to get rid of PMI decrease if you’re able to deduct mortgage interest and PMI on your taxes.
I mentioned those are tax-deductible expenses. A fixed-rate mortgage that costs four percent may only cost you about 3 percent on an after-tax basis depending on your effective income tax rate. So all this to say in general, prepaying a mortgage to eliminate PMI ahead of schedule may not help you as much as paying down other types of debt depending on where you live. Factors such as real estate appreciation and general inflation are likely to work in your favor, making you eligible for PMI cancellation sooner than you may think.
A super simple way to evaluate the interest rate you’re paying for a mortgage with PMI is to tack on a percentage point or two. For instance, if your pre-tax mortgage rate is 4 percent, consider it actually costing you. You know, you could say 5 percent or 6 percent tops with the PMI or if you deduct interest and PMI from your taxes, then maybe just don’t factor that in and just consider the mortgage costing you the same as its stated interest rate or 4 percent.
In my example, so kind of figuring that, OK, you’re going to get a benefit from the tax deductibility, but you’re also paying PMI and so maybe they wash each other out. And again, just sticking with your stated interest rate and thinking about it costing you that much.
So if your other debt costs more than these very rough mortgage interest calculations, I’d be more aggressive about getting rid of them first. So for Danielle, I would say, you know, more than likely her student loan would be a better use of her money than paying a mortgage ahead of time just to get rid of PMI early. Again, going in order of highest interest rate to the lowest interest rate is typically the best approach. Now, I will say if you have a very small outstanding balance that you just are dying to get rid of.
You know, maybe it’s just a really tiny amount that she’s got on her auto loan and she just wants to get rid of it. There’s nothing wrong with that. I mean, even if it costs you slightly less in interest, sometimes it just feels good to get rid of a very small debt. That’s kind of been weighing you down. So I hope that helps. Danielle and I also mentioned that I had a related email that came in from Christy M., who has a very low rate mortgage. Her interest rate is 3.3 percent and she has a windfall of about $25000 and is really trying to understand whether it’s better to use that windfall to pay down that mortgage or to invest it. And I would say in your case, definitely invest it, Kristie. You are going to get a much higher return from your investment than you are from paying off your mortgage after taxes if you are deducting your mortgage interest.
I mean, your mortgage may only be costing you about 2 percent after taxes. You can get a higher return than that from investing. So for you, I would definitely suggest that you use it. Extra money to build your retirement or any other taxable types of investments that you might have. And if you want to learn more about paying off a mortgage early, you might look at podcast number 443 called Eight Ways to Pay Off a Mortgage Early. And I also talk about some of the disadvantages of paying off a mortgage early.
And basically the disadvantage is just that you could in a lot of cases use your money in better ways. Mortgages are relatively cheap debt and they come with tax benefits that can make them cost even less. So once you send extra money to pay down a mortgage, it’s tied up. You know, it’s gone. If you unexpectedly lose your job or you suddenly have a large expense, you’re not going to be able to tap that money easily, if at all.
So in most cases, you’re going to be better off using that extra money to invest in the future. So to sum up, one of the most important things to get a grasp on with your finances is understanding how much you owe. The interest rates that you’re paying and have a plan for eliminating debt in order that really make sense even if you don’t have extra money to pay off debt ahead of schedule. Tackling them in the right order is going to help you save the most interest so you can eliminate debt as quickly as possible.
Thanks so much for downloading the show and being a part of this community. Keep listening, learning and leveraging your resources to grow richer every single day. If you are overwhelmed by debt, you feel scared or you’re just confused about which debts to tackle in what order. I have a fantastic resource that will help. I’d love for you to join my best selling online class. It’s called Get Out of Debt Fast, approve and plan to stay debt free forever.
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