My wife and I are currently contemplating an interesting question: should we borrow against our retirement plans in order to make a 20% down payment and avoid PMI or an adjustable rate mortgage? We’ve arrived at an answer to this question, but it’s not an answer that works for everyone, so let’s work through the process we used before we reveal our decision.
First, we calculated what we’re going to spend on a home. We are currently looking at a $175,000 home. This means that a 20% down payment would be $35,000. We have easy access to a significant portion of this, but we would prefer to leave it as an emergency fund, so we’re going to use $5,000 of this for part of the down payment. This means we have to come up with $30,000 to avoid paying PMI.
Next, we estimated what our PMI would be per month. We used the GoodMortgage.com PMI calculator, calculating the sale price of the home at $175,000, our loan amount at $170,000, and our interest rate at 6.25% at 30 years, and it estimated we would have a monthly PMI payment of $147.33. It also estimated a monthly principal and interest payment of $1,046.72.
Then, we estimated what our payments would be per month with the full down payment. If we had the full down payment, we would be borrowing $140,000 on the home, which gives us a monthly principal and interest payment of $862.00 at the same rate over the same period.
How much more does it cost to not have the full down payment? Each month with PMI, we would spend $1194.05, while without PMI, we would spend $862.00. The difference in monthly payments is $332.05. However, what we’re really concerned about is how much each month goes towards equity, so we used the Bankrate.com mortgage calculator to see how much goes towards equity in each situation. We selected a few months during the life of the mortgage for comparison. With the PMI, we would be putting $161.30 towards equity the first month, and unless we overpaid (which makes things much more complicated), we would lose the PMI payments in the tenth month of the tenth year of the mortgage, at which point we would be putting $316.91 towards equity. On the other hand, without PMI, we would be putting $132.84 into equity, and in that magic tenth month of the tenth year, we would be putting $260.98 a month into equity.
What that means is that in the first month with PMI, we would be paying $1,032.75 to the bank with no real return, while at the magic month when PMI goes away, we would be paying $729.81 in interest. On the other hand, without PMI, we would be paying $729.16 in interest the first month, and $601.02 during that magic month.
In short, over the term of the PMI, we would be paying about $300 more a month in interest/PMI, and even after the PMI ends, we would still be paying about $125 a month in extra interest without borrowing, a point we wouldn’t arrive at for almost eleven years.
PMI is really going to hammer you guys. What about borrowing against retirement? My retirement plan allows me to borrow $30,000 for a home purchase at 4.125%, but it has to be repaid in ten years. Thankfully, this is a cash loan – my actual retirement investments are merely collateral for this loan. If I take out that loan, I will have to make a monthly payment of $305.52 per month for ten years, then it’s repaid. At that rate, the first ten years of the loan are roughly equal with or without PMI (regardless of overpayments). However, once those ten years are over, we will be saving about $125 a month by borrowing against the retirement account.
Thus, given our situation, we feel we are better off borrowing against retirement than accepting PMI. The key difference for us is that the borrowing does not affect our retirement investment directly and once the first leg of the loan is over (which is equally bad in terms of monthly payments, but we are paying more principal each month with the non-PMI route), we are in substantially better shape.
It is important to note that if our retirement borrowing actually took money from our retirement investments, it would be a completely different story, as investment losses in the retirement account would eat away pretty much all of the gains from the lower interest rate – and probably then some more, too. If you can’t get a loan with your retirement as collateral, you shouldn’t actually borrow directly from your balance.