Note: I was informed by several readers that PMI traditionally stands for private mortgage insurance, so I updated the article to reflect that.
Many first time homebuyers are daunted with the prospect of saving up six figures to afford that 20% down payment, so they often take out home mortgages for less than a 20% down payment. This usually means that the dreaded private mortgage insurance (PMI) is part of the deal.
What’s private mortgage insurance? PMI refers to an insurance policy on your mortgage. Lenders often require that borrowers who don’t have enough cash for a 20% down payment take out a PMI policy. This policy generally costs between 0.5% and 1% of your mortgage annually.
How do you get rid of it? Generally, your PMI goes away after filing paperwork with your lender. This usually requires that your house be reassessed and it be shown that you currently owe less than 80% of the value of your home.
For many people, reaching that 80% threshold and getting rid of that PMI is a major goal. Their philosophy is that they’re just throwing away that 0.5% or 1% a year on PMI that they can reclaim, so they hurry up to pay it off. While this makes a lot of sense at first, paying off your mortgage early to get rid of PMI might not always be the smartest choice.
Here’s an example that a reader sent me a while back. He had a mortgage at 5.875% fixed and a PMI at 0.6%. However, he also had an auto loan at 7% and a few outstanding credit card bills way over 10%. He told me he was paying the mortgage early to get rid of that PMI. I told him it was a bad move, and here’s why.
The best way to determine the true impact of PMI on your finances is to add together the mortgage interest rate and the PMI rate and use that as the basis to determine which loans you should pay off first. So, in the example above, the effective mortgage rate would be 6.475%. Thus, the smartest move for that person to make would be to pay off the credit cards and pay off the auto loan before worrying about prepayments on the home loan at all.
What about when the PMI disappears? Once the PMI is gone, it’s a good time to re-evaluate which debt should go first. Let’s say, for example, the individual above has a car loan at 6%. That person should pay off the home loan down to 80% before paying ahead on that car loan. Then, when the PMI is gone and the interest rate on the mortgage goes down to 5.875%, then the person should focus on getting the car paid off.
In short, don’t let the fact that you can make the PMI disappear cloud you from making sound debt repayment choices. Treat it as extra interest on the home loan and use that as the basis for determining whether mortgage prepayment takes precedence over paying off a car loan – just compare those rates.