Home purchasers who were obliged to take out private mortgage insurance (PMI) because their down payment was less than 20% of the price have the right to cancel it, ridding themselves of the monthly premium. Borrowers should take advantage of the opportunity if they can but they must meet the cancellation rules.
Under Federal law, lenders are required to cancel private mortgage insurance on most home mortgage loans made after July 29, 1999. Cancellation will occur automatically when amortization has reduced the loan balance to 78% of the value of the property at the time the loan was made. The borrower cannot accelerate this process with extra payments.
Under another provision of this law, lenders must terminate insurance at the borrower's request when the loan balance hits 80% of the original value. Borrowers can accelerate the process of getting to 80% by making extra payments.
Warning: A lender need not accept a request for cancellation if the borrower has taken out a second mortgage or had an excessive number of delinquencies in the prior two years, or if the property has declined in value.
If Fannie Mae or Freddie Mac own the mortgage, the cancellation rules apply to the current appraised value of the property rather than the value at the time the loan was made. Borrowers can request cancellation after two years if the loan balance is no more than 75% of current appraised value, and after 5 years if it is no more than 80%. The ratios are lower if there is a second mortgage, if the property is held for investment rather than occupancy, if the property is other than single-family, or if the borrower has had recent delinquencies.
Paying Off PMI as an Investment
Homeowners should view paying off PMI as a potential investment that can yield a high return. Until now, figuring out how large that return was exceeded the capacities of almost all borrowers, but no longer. My colleague Allan Redstone has developed a PMI payoff spreadsheet, which shows the investment required to eliminate PMI, and the rate of return on that investment, for each of three rules: 80% of original value, 75% of current value after 2 years, and 80% of current value after 5 years. The spreadsheet is on my web site and is available for anyone to download.
A unique feature of PMI payoff as an investment is that the amount of the investment is a specific dollar amount. Hence, the borrower's decision must consider not only the rate of return but also whether or not they have the exact amount required.
Here is an example. Three years ago, the borrower purchased a house for $200,000 with a 30-year fixed-rate mortgage of $190,000 at 4%, and a monthly mortgage insurance premium of $65. She expects to be in the house another 4 years. The house is now worth $225,000, requiring an investment of $11,098 to bring the loan balance down to $168,750, which is 75% of $225,000. The return on investment in dollars is the $65 a month insurance premium for 68 months, plus the $14,280 difference in the loan balance in month 84 when the owner expects to sell the house. The rate of return is 8.96%
Note that the $65 monthly saving in mortgage insurance extends for only 68 months because in month 69, the ratio of loan balance to original property value falls below 78%, which under the law requires the lender to cancel the policy.
Borrowers Paying Higher Premiums Earn a Higher Return
The example described above applied to a relatively low-risk transaction that carried a very modest mortgage insurance premium. The transaction assumed a single-family home, a purchase for occupancy, and a credit score of 800.
Borrowers with poor credit pay more when they borrow, but there is a reverse side to that coin. When they invest in reducing their obligations, the rate of return is correspondingly high. If the purchaser in my example intended to rent the house rather than occupy it, and if her credit score was 620 rather than 800, her insurance premium would be almost 6 times larger. In that event, the rate of return on the investment required to eliminate the insurance would be 39.26%.
How the Passage of Time Affects the Investment
Intuitively, it would appear that the sooner you pay down the balance and rid yourself of the PMI premium, the better off you will be, but this may or may not be the case. It depends on the circumstances and preferences of the borrower.
Consider the example given earlier where after three years the borrower earns 8.55% on an investment of $11,098. If the same borrower decided to make the investment after 4 years instead of 3, her dollar savings would be smaller because both the number of PMI premium payments and the balance reduction in the payoff month would be smaller. On the other hand, the required investment would be $7326 instead of $11,098, which might make it affordable, and the rate of return on investment would be 10.52% as compared to 8.55%.
In general, the longer the borrower waits to pay down the balance to the point where the PMI is eliminated, the smaller is the savings in dollars and in the investment required, but the higher is the rate of return on investment. The power of the spreadsheet is that it allows each individual borrower to adopt the payoff strategy that best fits her needs and capacities.
Comparison with Other Investments
In comparison to other investments, an investment in PMI payoff ranks very high on default risk, because there is none, and on expected return. The drawback has been the complexity of the process, which has made it difficult to determine exactly what the rate of return is. Eliminating this uncertainty is the reason we developed the spreadsheet.
For more unbiased advice on mortgages, visit my website The Mortgage Professor.