PMI vs. 2nd Mortgage

If you already have a 20% down payment saved, this lens will not apply to you. Congratulations on saving!

When Applying for a Mortgage, they often throw many many different rates, loan types, terms, and fee structures at you. It can all become very overwhelming and confusing even for those who are well prepared.

A new option that will be popping up more and more will be the option of taking one loan with PMI instead of the first mortgage of 80% and a second mortgage for the rest of the balance at a higher interest rate.

In the United States, homeowners earning under $110,000 adjusted gross income can deduct, for the 2007 tax year, some or all of the LMI/PMI premium on mortgages closed only in 2007.

Historically, many people have said to avoid PMI because it wasn't tax-deductible. For the most part, this was a good rule of thumb since price savings between the two rarely, if ever, outweighed the tax-advantages.

Now, a second mortgage and PMI have the same tax treatment. So which is better?

Follow these basic steps to figure out which is better (Just because your payment is lower does not necessarily mean that it is a better deal) Please note that I have approximated principal balances and done calculations relating to the starting balance. This means that the circumstances may change over time as balances change. I'll address that difference at the end of the post.

Prep: Grab a piece of paper and draw a line down the center. Put "Loan w/ PMI" on one side and "Two Mortgages" on the other. Along one side, write down the following information:

• The Term for each offer (15-year, 30-year, 5/1 ARM, etc..)


• Interest Rate for the Single Loan w/ PMI


• Interest Rate for EACH of the Two Mortgages (the 80% and the 2nd mortgage)


• Annual cost for PMI (if they gave you a monthly number, multiply by 12)


• 80% of your homes value (how big would the 80% loan be?)


• The percentage financed over 80% (usually 3,5,7,10,15, or 20)


• The Dollar Amount financed over 80% LTV (Loan-to-Value)

1. When comparing offers, make sure the loan term is equal. When comparing PMI and a second mortgage, only compare a 15-year fixed vs. another 15-year fixed, or a 5/1 ARM to another 5/1 ARM, etc. If you compare different loan types you introduce many other variables that make this calculation difficult, if not nearly impossible.


2. Compare the Interest Rate on the 1st mortgage for both loans. For the PMI loan this will be the rate on the entire balance. For the loan with the second mortgage, this is the mortgage with the lower rate of the offer with two mortgages (the loan for 80% of the value of the home)
   
   
   
   1. If the interest rates are equal, go to the next step.
   
   
   2. If they are not, perform the following calculation:
      
      
      
      1. Subtract the higher interest rate from the lower (i.e. if the PMI loan is 7% and the 80% loan is 6.875% you would get: 7% -6.875%= 0.125%)
      
      
      2. Multiply the difference in interest rates by 80% of your homes value (it should be written on the side of your sheet! :) ) ($120,000 * .125%(0.00125) = $150)
      
      
      3. Write this dollar amount down under the loan column with the higher interest rate.
      
      


3. Compare Effective Interest Rate on the remaining balance.
   
   
   
   1. Take the annual PMI cost and divide it by the balance of the PMI loan that is over 80% (if additional balance is $25,000 and PMI is $700/yr you would take 700/25,000 = 0.028 = 2.8%)
   
   
   2. Add this total to your interest rate for the PMI loan (i.e. 7% + 2.8% = 9.8%) This is your effective interest rate for your PMI loan in the first year.
   
   
   3. Compare your Effective Interest rate with the offered interest rate on the second mortgage. Subtract the larger from the smaller and multiply by the remaining balance (i.e. 9.8% (PMI Loan) - 8.6% ( Two Mortgage Rate) = 1.2%; 1.2%=0.012 ; 0.012 * 25,000 = $300)
   
   
   4. Add this number to the column with the higher rate.
   
   
   
   


4. Add up the columns.


5. The column with the lowest dollar amount is the better deal for the first year.

Thoughts and Disclaimers

• On the two mortgage scenario, your interest rate will remain constant relative to your balance for the life of the loan.


• The PMI loan will have a higher effective rate as time goes on (using the example above, once your additional loan amount reaches $20,000 your PMI will still be $700 / yr meaning your effective interest rate would climb from base + 2.8% to base + 3.5%)


• Once you reach 20% equity in the home through paydown and appreciation you can have PMI removed, permanently reducing your effective interest rate.