PMI-Private-Mortgage-Insurance-Is-PMI-Bad

In Defense of PMI

When a Low Down Payment can be a Good Strategy for Buying Real Estate – A Case Study for a 5% Down Payment with Private Mortgage Insurance (PMI)

Disclaimer: this is meant to be informative and is my opinion, not financial advice

Conventional wisdom recommends a down payment of 20% on a house purchase. Sounds great…if a 20% down payment on a house in your market is within range. However, in higher priced real estate markets like the Boston area this can seem unachievable for many.

An alternative to the 20% down payment, is to put down a lower down payment. In cases where someone puts down less than a 20% down payment on a house, lenders often require PMI, or Private Mortgage Insurance. This is an additional monthly fee added on to a mortgage payment, and it’s not tax deductible. A lower downpayment constitutes a higher risk of the loan holder defaulting, so the PMI exists to offset that risk for the lender.

I was in this position about 2 years ago, wanting to get into the real estate market. Coming up with a 20% down payment in the Boston area where I was wanting to buy a two-family under $600,000 seemed unfathomable. Instead of trying to get a 20% payment, which could have been as much as $120,000, I decided to put down a 5% down payment, and am glad I did. By doing so, I ended up with a monthly PMI payment of $152 but I also saved myself from coming up with and putting down $78,000. I expect to remove the PMI soon and the rental income is more than offsetting the PMI and the added interest I am paying from the lower down payment. So, lets dig into what that looked like.

Is PMI Really that Bad?

In my opinion PMI gets a bad wrap. No one wants to pay an extra fee on top of an already big expense. However when utilized appropriately, having a loan with PMI and a lower down payment can be a much better strategy than putting 20% down.

The actual amount paid can be nominal (all things considered). For example, I pay $152 a month on an almost $500K mortgage where I put 5% down. I pay $65 monthly on a $280K second home mortgage where I put 10% down. There are variables here, so it is different in each individual case. When you compare this monthly payment to the amount of cash I would have had to come up with to make a 20% down payment, it doesn’t seem bad at all.

The traditional advice of putting at least 20% down does heed a warning: It is always important to make sure that monthly mortgage payments are affordable for the person taking it on. Adding PMI into the mix can make a payment that was already a reach a high risk situation. However, if the payment with the PMI is still within range, then carry on.

PMI also doesn’t have to be permanent as there are ways to get it removed, which I have successfully done before in the past. I’ll talk more about this in a post in the future, but her are some cliffnotes below.

Potential Ways to Remove PMI – Depending on the Loan:

  • When the equity percentage in the house reaches 20% over the course of time
  • Re-Financing
  • If the house increases in value, a broker price opinion that evaluates the current market value to give you a Loan to Value ratio of over 20%. This is a strategy that I’ve used before successfully and plan to try again.
  • Pay down mortgage to 20% equity

Considerations when Deciding on a Down Payment Amount in an Expensive Real Estate Market

Back in 2018, I had about $25-$30K set aside, and was contemplating using it to get into the Real Estate market. I wanted a two-family and after talking to a mortgage broker and accessing the area, I decided I want to pay under $600,000. Conventional wisdom would tell me I needed 20% to put down, which could run me as much as $120,000 which was and is a big number to me personally.

Down Payment Options:

  • Option 1: Put down a 5% down payment ($30K Down on $600K property) and pay the monthly PMI
  • Option 2: Take on a Partner to get to a higher DP
  • Option 3: Be gifted money to get to a higher DP if possible
  • Option 4: Wait and try to personally save up to 20%
    • This makes 0 sense for a number of reasons. Say I can put aside $20K a year in addition to the $25-$30K I have set aside. That will take me another 4.5 years to save up to $120K, and who knows what could happen in that time to my personal situation. Also, in the meantime I will have missed out on 4.5 years of making income from a property, and will be tied up paying for an apartment somewhere. Additionally the market could be in a different place, assuming basic inflation, the additional 90K I need could turn into $100K, further pushing me out. The opportunity cost is simply too high. If you were to find a good value place it doesn’t make sense to say no to it due to not having a high enough down payment.

Real Life Scenario:

What ended up happening back in 2018, was that I came across a property for a great value in Malden, Ma and settled upon a price of $521,500. See more about that here. I put down a 5% down payment and pay the monthly PMI which on my loan is $152 a month.

The Costs of the Low Down Payment

Here is what my mortgage looks like. This isn’t including closing costs, taxes, utilities or insurance. As shown below, I put down a down payment of $26,075. A 20% down payment would have run me $104,300, a difference of $78,225.

Property Cost$521,500
Mortgage Interest Rate4.5%
Mortgage Term30 Years
Down Payment %5%
Down Payment $$26,075
Loan Amount$495,425
Monthly Principal and Interest$2510
Monthly PMI$152
Mortgage Stats

Let’s look at what the PMI cost me over 2 years. I plan to have it removed shortly after the 2 years is up… more to come on that.

PMI Monthly CostAnnual Cost2 Year Cost
$152$1,824$3,684
Example of Cost of PMI on a $521,500 property w/ 5% Down Payment

A 2 year cost of $3648 vs. putting $78,225 more down…. kind of a no brainer. However, that’s not the full picture. PMI is not the only consideration for a low downpayment. Additionally the interest portion of a mortgage payment goes higher the less of a down payment there is.

For example, my mortgage payment is $2510 a month (On $498k original amount) with 5% down. Had I put 20% down, it would have been $2114, which is a difference of $396.

5% Mortgage Payment Monthly Cost 20% Mortgage PaymentMonthly DifferenceAnnual Difference2 Year Difference
$2510$2114$396$4752$9504
Example of Difference in Interest Cost on a ~$500K Mortgage

So after 2 years, that’s another $9504 that I’ve paid in interest than if I had put 20% down.

CostAnnual Cost2 Year Cost
PMI$1,824$3,684
Added Interest$4752$9504
Total$6576$13,188

Over 2 years the lower down payment cost me $13,188, but again I prevented spending $78,225 in money I did not put down so after 2 years I’m still ahead $65,037.

If you project the difference in the total cost of the mortgage across the life of the loan (30 years), the numbers start to get scary, due to the added interest difference. I got the below mortgage figures from my own mortgage info, and by using a mortgage calculator online.

Interest Rate & Loan length% Down
$
Amount DOwn
Monthly
Principal & Interest
Total PaymentsOriginal Loan Amount
4.5% – 30 Year Mortgage5%$26,075$2510$903,688$495,425
4.5% – 30 Year Mortgage20%$104,300$2,114$761,001$417,200
Difference15%$78,225$396$142,687$78,225
Mortgage Comparison on a $521,500 Property

If I were to hold onto the same loan and the property for 30 years, the difference in the down payment would cost me $142,687 more plus the PMI I incurred (estimate $3,684) so about $145K. Wow! That sounds like a lot. However if I subtract the difference in down payment amount that I didn’t put down originally ($78,225) I’m at roughly $67,000. Still alot! I would only realize this figure if I kept the same loan for the full 30 years.

However, can I make that money up somehow? The answer is possibly. My break even point is about halfway through at 13.5 years ($67,000/average interest of $4700 after subtracting first two years of PMI), where until after that point, my lower down payment did not matter. If I don’t do any of the below and keep the loan after 13.5 years, then it will start to cost me.

Ways to Counteract a Low Down Payment Costing Over Time in Interest:

  • Re-finance into a lower interest rate to less payments if possible
  • Property Sale – Eventually sell the property, hopefully at an appreciated value
  • Add more money into the mortgage to pay down the principal and therefore lessen the interest
  • Invest the money you didn’t use for the downpayment as you come up with it annually.
    • Example: If I invest $5,000 a year and assume a 7% return rate each year, I will reach $65K in about 9 years, having broken even already with the additional lifetime cost of my mortgage.
  • Rental Income – This could way more than offset the additional cost of the lower down payment, situation depending. See my example below

Rental Income

An important consideration for my scenario is the addition of rental income from the unit that we don’t live in.

Monthly RentAnnualTwo Years
$2100$25,200$50,400

This disregards my expenses from the rental property and other factors. This rent pays for half of the mortgage and all other expenses before I account for a cash flow of about $500 monthly. So if I consider the extra amount I am paying in PMI/interest ($396 per above) half of that is covered by the rent payment before cashflow as it is built into the mortgage. So I am left with $198 out of my own pocket. That $198 is offset by the cashflow I am making from the one unit. So it my case, the added cost of PMI and the added interest from the low down payment are a wash because of the rental income I am receiving from the other unit. This is a reason why I would consider a low down payment on a house hack property a great strategy for getting into the real estate market with a low down payment.

In summary – PMI can be a minor nuisance worth taking on if the situation calls for it. If I had followed the advice to get a 20% down payment, I would currently have 0 properties, and 0 rental income. The only options are not 5% and 20%, it could be anywhere in between as well – 10% – 15%, etc. PMI is not the bulk of the cost of putting down a lower down payment, its the added interest you end up paying. So it is certainly a decision worth weighing.

My thought would be to determine a target price, then see how difficult it will be to acquire a 20% down payment. If there is a long runway ahead, consider a lower down payment, think about the long term plan, and run some scenarios with mortgage calculators and a mortgage broker.In a situation like mine where I am making rental income, I have found the decision to make the purchase with the low down payment a good one. If I wasn’t going to be making rental income, I may have gone a different route. I have been successful with removing PMI early before and plan to go into this topic more at a later date.

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