Saving up a “traditional” 20% down payment can be difficult for many individuals. As a result, many borrowers end up paying private mortgage insurance (PMI), in order to cover the lender’s risk that the proceeds from foreclosing on a property would not be sufficient to cover the outstanding liability of a mortgage. On the one hand, PMI is therefore valuable to borrowers as it creates opportunities for homeownership for those that don’t have enough cash saved up to put 20% down (it is effectively the “cost” of buying a home without a traditional down payment), but, at the same time, PMI can seem like an expensive drain on a borrower’s cash flow, making it enticing to pay down the debt to eliminate the need to pay PMI.
In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – examines how to determine the ROI from prepaying a mortgage to eliminate PMI, and finds that although the ROI can be high over short time horizons, the ROI from eliminating PMI over longer time horizons is often much lower.
PMI is generally required on a mortgage with a long-to-value (LTV) ratio of less than 80% (i.e., less than a 20% down payment). Because PMI is actually a form of insurance for the lender rather than the borrower, the reality is that PMI is functionally the same as a higher interest loan taken out on whatever amount would be needed to be prepaid in order to reduce the LTV ratio to less than 80%. For instance, if a borrower pays $1,200 per year in PMI premiums for a $200,000 home with a 5% down payment, then the borrower is initially paying an effective $1,200 of interest on a loan equal to the additional 15% ($30k) that would be needed to be prepaid in order to avoid PMI. Which is not an insignificant amount of interest, as $1,200 of annual interest on a $30,000 loan is effectively 4% loan on top off whatever the underlying interest rate is. So, if a borrower is paying 4.5% on a mortgage, then the total cost of the additional “loan” (PMI) is roughly 8.5%. Further, since this assumed $1,200 premium does not reduce as the balance needed to get below 80% LTV declines, the cost of keeping this “loan” in place increases with time. For instance, a borrower paying $1,200 per year in PMI on a mortgage that is only $5,000 away from eliminating PMI is effectively paying a rate of 24% on top off whatever their underlying mortgage rate is!
However, this 8.5% only represents a short-term ROI over a single year time period, and a key consideration in determining the long-term ROI of an investment is the rate at which it can be reinvested. Since pre-payment of a mortgage is effectively “reinvested” in a stable investment that “only” earns an ROI equivalent to the mortgage rate itself, this creates a long-term drag on the ROI from prepaying a mortgage (as funds are then tied up in debt repayment rather than investments which may have a higher long-term expected returns). And over long enough ROI time horizons (e.g., 30-years), the ROI of eliminating PMI effectively approaches the same ROI as prepaying the mortgage itself (albeit slightly higher due to some benefit that remains from the initially higher ROI). Which is important to acknowledge because while PMI elimination can look highly attractive based off of a single year ROI, failure to appreciate the differing short-term and long-term ROIs can lead investors to make pre-payment decisions which may not align with their long-term goals.
Of course, pre-payment of a mortgage to eliminate PMI may still be an attractive investment (particularly on a risk-adjusted basis), but the reality is that the time horizon used to evaluate the decision has a substantial impact on the long-term ROI. And given that it is the long-term impact that is most important for investors to consider, deciding whether to eliminate PMI may not be as much of a “no-brainer” as simply calculating the single year ROI may lead us to believe!