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I would like to understand whether it is better to make extra payments on a home loan that includes PMI (Private Mortgage Insurance) or a different (high interest) loan.

Typically, when deciding between paying off one loan or paying off another, I would choose the loan with a higher interest rate. However, PMI complicates this calculation. Once one reduces a home loan's balance to 78% LTV, the PMI must be cancelled by the lender. (It can be cancelled earlier in some cases, such as at 80% LTV.) I'm not sure how to reason about what this does to the loan's interest rate.

I've included an example below, since it seems like an explanation would be easier with real numbers.

Example

  • Loan 1. Home loan

    • Home value: $100,000
    • Loan balance: $90,000
    • Interest rate: 2%
    • PMI rate: 1%
    • Lender will drop PMI when loan reaches 80% LTV

  • Loan 2. Unsecured loan

    • Loan balance: $5000
    • Interest rate: 10%

How do I reason about which loan to make extra payments on?

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3 Answers 3

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I'd need to find my other post here on PMI, but the point I'd bring here is that (a) the PMI is an adder on the entire balance due to the $10K shortage. So $900 expense on the $10K, and (b) the question of whether the bank will be willing to drop PMI if you are that one payment. PMI is only dropped automatically when you get to be 80% level due to natural amortization.

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    The previous discussion is here in which it was discussed that PMI must be removed when the outstanding loan balance drops to 78% or below (not 80%) of the original home value due to natural amortization. Some lenders might drop PMI upon request by the homeowner) if the balance reaches these limits (or even 80%) earlier due to extra payments early in the life of the mortgage, but might refuse, or demand another appraisal (to be paid for by the homeowner, of course) etc.
    – Dilip Sarwate
    Commented Jun 30, 2013 at 23:34
  • This lender will drop PMI upon request when the loan reaches 80% LTV. I'll edit the question.
    – Eric
    Commented Jul 1, 2013 at 1:32
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If you reduce the home loan from $90K to $80K you would thus reduce this interest rate from 3% to 2% (without the PMI) thus saving you $900 in interest (from the original $90k). If on the other hand you paid off the $5000 @ 10% you would be saving $500 on interest.

So up front it looks more advantageous to reduce the home loan from $90k to $80k, but is this really the case?

What would be the case for instance if you had a spare $1000, which loan would it be better to put it in?

If you put an additional $1000 into the home loan you would reduce your principal to $89K and reduce your interest payable by $30 per month (3% of $1000). However, if you put the additional $1000 into the unsecured loan you would reduce your principal to $4000 and reduce your interest payable by $100. (10% of $1000).

So it is thus better to still pay down the loan with the higher interest rate. Once you have paid this small but high interest rate loan off you will also have more ammunition to pay down the home loan to $80k much quicker.

Edit: There is one exception, if you can reduce your home loan straight away to $80k (with a $10k windfall) this would be more beneficial than paying the $5000 loan and reducing the home loan to $85k.

So if you can reduce the home loan to $80k very quickly do that first, but if you are making extra repayments over months or years you are better off paying the $5000 @ 10% first.

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If you had a spare 5K and confidence that you wouldn't go bankrupt in the near term, the best return would be to pay off the unsecured loan first.

Paying off the unsecured loan completely will free up the money that was going to the minimum payment, this extra monthly cash would get you quickly to the 80% LTV on the mortgage. If you are itemizing your deductions it keeps the deductible interest and reduces the non-deductible interest. It also has a psychological value, because you have completely eliminated one of your debts.

Paying additional funds over time to the unsecured loan will eliminate that payment earlier, which has a more direct impact on you monthly payments.

There are risks. If the reason you have the 5K debt was bad financial habits, and you repeat the, your improved financial situation will be short lived. In addition unsecured and secured debts are handled differently in bankruptcy.

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