Lower rate with PMI or higher rate?

Question

I'm currently in the process of looking for home to buy, and one of the options is one costing 460K, which I plan to pay with 15% down and the rest (391K) financed. Since it's less than 20% down, the bank offered me two options - pay mortgage insurance (PMI) - about $100/month, with rate of 4.25%, or pay 4.625% and no PMI. Monthly payments in both cases are roughtly equal (less than $20/m difference).

I am considering taking PMI/low rate option, since as far as I understand, I could cancel the PMI once I reach 80% equity (which will take 4 years on amortization schedule, if I built it right), and also looking at the amortization schedules, I end up paying significantly less interest this way. Also, if I would want to resell the home, the balance on the mortgage is lower each year of the schedule, which means I'll get more money if I sell before the end of the loan. There's also an issue of interest being tax-deductible, but I didn't figure out yet if it matters (I think not, but not 100% sure).

However, I got a feeling that the bank representative (though she didn't say it directly) thinks no-PMI option is much better. I wonder if I'm missing something or it's because it's better for the bank (since I'd end up paying more interest)?

Answer 1

You understand it perfectly right. The thing with PMI is that when your home price rises (or your loan balance goes down) so that your loan balance is below the 80% of the current house price, the PMI goes away. The higher rate - does not. So, no-PMI option is much better. To the bank, as you suspected.

Your calculations are correct. With the PMI you'll pay less interest, and more balance. As to the tax deductions, interest can be deducted, but the PMI - no (starting of 2012, to the best of my understanding, at least). See details here, consult a tax professional for more current information.

Answer 2

There may be a third option. The bank gives you the first mortgage of 80%, and a second, maybe a HELOC, for that missing 5%. This way, you get the lower rate and the money they'd charge you for PMI goes to paying down the second loan. Alternately, do you have any other sources to tap to bridge this small gap? A 401(k) loan perhaps? The rate willbe low, and for home purchase, a 10 yr payback.

If these aren't viable options, I agree that taking the PMI route while tracking the balance is the way to go.

Answer 3

IMO the right path usually depends on how long you depend on staying in the home and how much you put down.

The idea behind paying the higher rate is that you can easily recoup $0.25-35 on the dollar in taxes if you go with the higher rate -- at least for the first few years. But that "benefit" becomes less valuable over time, as you pay more interest in the beginning of the loan.

It's a good deal in many cases, as the trend over the last few years is to put 5% or less down, and most people stay in homes for around 7 years. In your case, you are putting down a substantial down payment, and with only 4 years to 80% LTV (or less, if the market improves), taking the lower rate with PMI makes more sense.

Answer 4

You could check with the new 401k provider to see if they allow rollover-in contributions. You can likely take the exact amount of the rollover check that was put in the IRA and put it in the new 401k and then take a loan. Loan amount is calculated as 1/2 vested balance less any outstanding loans or $50k, whichever is less. Hopefully this helps...