Can PMI Be a Good Thing?

This week, I’m going to take a look at a few of the longer questions that have been languishing in the reader mailbag. These questions were too long for a regular mailbag post – and deserve a longer answer – but are well worth discussing on The Simple Dollar.

Nick is thinking deeply about two mortgage offers on the table before him:

I’ve been at my job for about 2.5 years, my fiance at hers for about a year and a half. We’re getting married next month. We have a combined gross income just shy of $90,000 annually. Within the next month or so, both credit cards will be paid off. Remaining debt is $9500ish on a car loan @ 9.24% (30 months remaining @ $342/mo). We have a combined amount of around $40,000 in student loans with rates between 2.75% and 5.8% – payments are $505 monthly. My fiance has had some financial issues in the past, but she finished paying off delinquent accounts last year. We are currently paying $1100/month in rent for a 2br/1.5ba townhome, plus about $200/mo in utilities. I’ve missed one utility/loan/credit card payment in the last 7 years, and it was only by 3 days so I’m not sure if I even get dinged for it.

Anyway: We’re ready to start looking at purchasing a home. I majored in personal financial planning in college. In my PF classes before the housing bubble burst, the instructors unanimously said it was a terrible idea to buy a home with no money down. As a general rule of thumb, I cannot say I disagree with them. However, being a finance guy, I also like to look at numbers. With the current state of the housing market and crazy low interest rates, to me it almost seems like purchasing a home NOW would be a great choice, even though I don’t have any money to put down. That is, assuming my fiance and I could get approved for such a loan.

No matter how we do it (0% down or ~10% down), PMI and property taxes will be the same. Waiting for a full 20% down is not something we’re wanting to do when purchasing. We’d be paying rent for far too long.
PMI @ $160 / mo.
Estimated property tax @ $250/mo

Now for the mortgage bit:
If we could buy now, 0% down:
Value of loan: $280,000
Interest rate: 5.25% fixed
30 year mortgage, likely to make extra payments
PMT on mortgage = $1539.44
Total if we paid for 30 years: $554,198.40

Let’s assume 3 years from now (time it would take to get 10% down) that home prices go up 7% and interest rates go up 1.5%. I may be right or it may swing the other way. We don’t know what home prices will do, but we do know that interest rates cannot realistically go down any further. In this time period, we could manage to save up $30,000 for a down payment, which also likely would lower our interest rate slightly (6.25% instead of the new value of 6.75%).
Value of loan: $266,800 (New value of $296,800 minus $30,000 down)
Interest rate: 6.25% fixed
30 year mortgage, likely to make extra payments
PMT on mortgage = $1634.22
Total if we paid for 30 years: $588,319.20
PLUS initial $30,000 down
Total mortgage + down pmt = $618,319.20

Paying $554,198 plus a few extra years of PMI (est. $6000 over 3 years) for a house sure sounds better than $618,319.

Now…..I understand the whole risk thing associated with buying and putting no money down — you have no equity so if you need to sell and the market slumps, you’re liable for THAT much more. I grew up in this area – both of our jobs are relatively secure, we love the area. It has great schools for future children, great public facilities (libraries, etc), and lots of walking paths and parks. We don’t plan on relocating anytime soon.

I understand that we’d pay somewhere around 3 years extra of PMI (rounded up to $6000 total). I understand it would take a while and some extra payments to really get some equity in the home. And I also understand that this might all be a moot point if we can’t get approved for a mortgage with less than 10% down. But my question is…am I missing something? Is the market THAT much of a buyer’s market right now that the math on this looks the way it does? Or is this still a terrible idea?

Nick’s two offers give us an interesting comparison between the different benefits and risks that a potential homeowner needs to think about. Let’s walk through some of them before I offer up my specific thoughts on what Nick should do.

Where will interest rates go? Right now, interest rates on home loans simply can’t go much lower than they currently are. The difficulty, of course, is predicting when interest rates will begin to rebound. Three years from now, interest rates might be just where they are right now… or they might be higher. It depends on a multitude of factors, many of which simply boil down to a question of whether or not the economy will improve.

To put it simply, waiting is a risk in terms of interest rates.

What will happen in your future? Will you remain employed in the current area? Will you want to live in that area in the future?

It’s very hard to tell what a person’s future holds for them. We like to see a future that’s bright and is a direct positive continuation of what we’re doing now, but that’s rarely what happens.

The best way to mitigate this risk is to minimize one’s monthly payments, which is itself a careful balancing act between the small down payment and low interest rates now and the larger down payment and potentially higher interest rates later on.

What will the housing market do? Will the home you buy retain its current value? Will it go up, or will it continue to slide in a weak housing market?

Again, it’s hard to tell what will happen here, but it is important because if you need to sell the home for some reason, as Nick mentioned, you may be faced with a loss compared to what you bought it for. If you buy the house with no money down, then you will have built very little equity in the house, meaning the sale won’t net you anything and you might even have to come up with some shortfall.

The real crux of this matter is an uncertain future. You can easily create a model for a future in which buying now is the right choice. You can just as easily create a model for a future in which waiting to buy is the right choice.

Given a scenario like this, I would almost always choose to be conservative. If I were you, I’d start aggressively saving up for that down payment and keep an eye on interest rates. If you start to see any indication of a significant uptick in rates, that’s the moment I would start shopping for a house, because that’s the point when you combine the best of all worlds. You’ll have a down payment, you’ll still have very low interest rates, and you’ll also have a year or two more under your belt so that you have a better grasp on where your life is headed.