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I'm looking at two options for a home improvement loan (around $20,000): the first is a federal title 1 loan, which would be a fixed interest rate of around 4.5% (at the time of initial quote), BUT requires PMI at around $20/month. The other option is a HELOC, which doesn't require PMI, but has a variable rate (which will almost certainly only go up over the life of the loan) of 6%.

According to my math, if the rate on the HELOC goes up more than 0.4%, then it becomes more expensive than the Title 1, meaning that if I pay off the loan over 15 years, the Title 1 loan, even with the PMI attached, would almost certainly be the cheaper option.

Where I'm still a little fuzzy is what happens if I pay the loan down more quickly - say over 7 years rather than 15? Is there a point where the HELOC would become the cheaper option, even with the rate going up? That is, is there a point in paying down the loan where that $20/month outweighs the higher interest rate on the HELOC? Or does the likelihood of the rate going up significantly almost always make the HELOC the more expensive option?

  • It seems unlikely. Whatever you would pay extra on the HELOC to pay down the principal faster could also be used to pay down the title 1 loan faster. Further, there will come a time when you can request that the PMI be dropped (and at some point, I believe the lender will be required to drop the PMI). This is without considering the possibility of the HELOC rate going up. – chepner Sep 21 '20 at 17:23
  • @chepner Actually, since this is a federal Title 1 loan, not a mortgage, the PMI is required for the life of the loan. I'm well over 20% equity on my home, so on a typical mortgage there would be no PMI. Apparently these Title 1 loans are a different animal. Which is not to say that you are in any way wrong about the rest of it, I just don't have the math... – ibrewster Sep 21 '20 at 17:26
  • What are the actual minimum payments on each? – chepner Sep 21 '20 at 17:45
  • @chepner: the HELOC would be interest-only minimum, but I would intend to pay it down more quickly, so at 15 years it comes to around $174/month, assuming no change on interest. The title 1 I calculate at $157/month+$20 PMI=$177/month (roughly). None of these number are final yet, so everything is subject to change. – ibrewster Sep 21 '20 at 18:39
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"That is, is there a point in paying down the loan where that $20/month outweighs the higher interest rate on the HELOC?"

Yes - the reason for this is that your fixed PMI increases as a % of your outstanding loan balance, as your loan balance decreases. If PMI is a fixed $20 / month ($240 / year), then it starts out as 1.2% of $20k, but when your balance is $10k, it is effectively 2.4% of your outstanding balance. So it's 5.7% total rate to start on your Title 1 loan, vs a starting 6% on the HELOC, but half way through payment period, it would be 6.9% for the Title 1 loan vs whatever the HELOC has adjusted to at that point in time.

If you pay down just the monthly fixed amounts for 15 years, I calculate your all-in interest costs of a Title 1 loan of 10.9k over 15 years, vs 10k with a HELOC, assuming the rate stays constant [which is a risk]. If the HELOC jumps immediately to 6.5%, that would be about even with the Title 1 loan.

If you pay down the loan twice as quickly at 7.5 years, your all-in interest with the Title 1 loan would be 5.3k vs 4.7k with the HELOC. Still better with the HELOC, but with the difference narrowing, which would make the two options cost the same in interest if the HELOC rate jumped immediately to 6.7%.

The 'worst case scenario' where the PMI-including loan performs the worst compared with the HELOC, would be if you paid down, say, $10k immediately through some windfall, but then took the full 15 years to pay off the remainder. In that case, you face the full brunt of the PMI which could easily outweigh fluctuations on the HELOC in the meantime [although risk of rate increases would persist]. This would be equivalent to about an 8.5% HELOC.

So if you make payments evenly over time, the impact of the fixed PMI as a proportion of interest cost is not so pronounced and therefore the HELOC is attractive but for the risk of interest rate change, but if you sporadically make payments against the principal balance and then continue for the full available term, then the Title 1 loan looks the worst.

  • So excluding the "worst case scenario", it sounds as though it is kind of a toss up, with the HELOC possibly being a bit better, but potentially (likely?) getting worse, and the faster I pay off the loan the less benefit the HELOC would offer anyway. Assuming I am understanding you correctly :) – ibrewster Sep 21 '20 at 21:39
  • You are understanding correctly, as long as you don't decide to pay down most of the balance in the next few years and then stretch out payments until the end of 15 years - in that case, the proportionate impact of PMI hits much harder than the HELOC rate risk. – Grade 'Eh' Bacon Sep 22 '20 at 0:52

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