December 6, 1999, Revised December 3, 2007
Whether paying a higher interest rate is better or worse than paying mortgage insurance depends on a variety of factors, including how long the borrower expects to have the mortgage and how rapidly the property appreciates. All the factors can be pulled together in calculator 14a.
Mortgage Insurance Versus Higher Interest Rate
"We have a 5 percent down payment and our lender has offered us a Tax Advantage Mortgage Insurance plan instead of conventional private mortgage insurance (PMI). Instead of paying a mortgage insurance premium, we pay a higher interest rate. The lender says we come out ahead because the higher interest payments are tax deductible. The rate on the Tax Advantage loan is 8.375 percent compared to 7.5 percent on the conventional loan. We are in the 28 percent tax bracket. Is this a deal for us?"
Virtually all lenders in the US require PMI on mortgages with down payments less than 20 percent, but some will accept a higher interest rate in lieu of PMI. When a borrower accepts this option, the lender buys PMI for less than the borrower would have to pay. The higher interest rate covers the insurance cost to the lender, perhaps including a profit margin.
The sales pitch for the higher rate as a replacement for PMI is that interest is tax deductible whereas PMI premiums are not. The other side of the coin, however, is that you must pay the higher interest for the life of your mortgage, while mortgage insurance will be terminated at some point.
In 1999, Congress mandated that on most loans closed after July 29, 1999, mortgage insurance must be cancelled at the borrower's request if the loan balance is paid down to 80 percent of the original property value. Further, insurance must be terminated automatically when the balance reaches 78% of original value. In addition, subject to certain conditions, PMI on loans sold by lenders to the two Federal agencies (Fannie Mae and Freddie Mac) must be cancelled when the loan balance reaches 75% of the current property value, after 2 years, and 80% after 5 years. See Cancelling Private Mortgage Insurance 1 and Cancelling Private Mortgage Insurance 2.
Using Calculator 14a to Get an Answer
There is no way you can figure in your head whether the higher rate or PMI results in a lower cost. However, calculator 14a,Pay For Mortgage Insurance or Pay a Higher Interest Rate will do it for you. To crunch the numbers you'll have to give the calculator relevant facts about you and your mortgage, including:
Tax Bracket: Because of interest deductibility, the higher your tax bracket, the greater the benefit of the higher rate relative to PMI.
Life of Mortgage: Because tax savings are highest in the early years, while mortgage insurance premiums decline or disappear entirely at some point, the relative advantage of the higher rate is greatest if you expect to be in your house only a short time.
PMI Premium: The higher the PMI premium, the more likely the higher rate is a better deal. Premiums vary with the type of loan, term, down payment and other factors.
The Rate Increment: The smaller the increase in the interest rate charged in lieu of PMI, the greater the advantage of the higher rate loan.
Property Value Appreciation: Appreciation can lead to early PMI cancellation, as noted above. For example, assuming 5% down on a 7.5% 30-year loan and property appreciation of 1% a year, the loan balance reaches 80% of value in 93 months; with 2% appreciation, the target is reached in 67 months; and at 3%, in 52 months. ThePay For Mortgage Insurance or Pay a Higher Interest Rate calculator allows you to explore how these possibilities of early termination affect the relative cost of the high-interest rate option.
In your case, I first assumed that termination of PMI does not occur until the loan balance reaches 78% of original property value. In that event, the higher interest rate loan would be the better deal if you hold the mortgage less than 24 years. Then I assumed that termination occurred when the balance reached 80% of appreciated value, and that your house appreciated by 1% per year. This was sufficient to reduce the cross over point to 13 years. With 2 percent appreciation, it falls to 8 years, and at 3% to 6 years.
Bottom line: If you expect significant appreciation and monitor your property value so you can terminate PMI as soon as possible, the higher interest rate option is a poor choice -- unless you expect to hold the mortgage a very short time.
The Public Policy Issue
The higher interest rate option usually means that the lender is purchasing the mortgage insurance and passing the cost along in the rate. This may or may not offer a better deal to the borrower, but in the long run, a system in which lenders buy the insurance is better for borrowers than one in which borrowers pay for the insurance. Lenders purchasing insurance have an incentive to drive down the premium, whereas there is no such incentive when borrowers pay the premium. For further elaboration, seeSingle File Mortgage Insurance.
