In this article we look at what PMI is, why it hurts you financially, and how you can get rid of it to save money. A PMI calculator estimates what your effective interest rate is when you pay PMI so that you know exactly how much PMI is costing you, and whether removing PMI should be your first priority when paying off debt.
What is PMI?
PMI is a tool that allows banks to make mortgage loans to people who they might otherwise consider to be too risky to lend to. When looking at how risky a mortgage loan is, one of the key ratios banks look at is called the LTV, or loan to value. It can be calculated by dividing the balance of your loan by the original purchase price of your home. When you are taking out a loan, your goal should be to have a LTV of 80% or less. If you have a LTV of 80% or less, the bank figures that even if you don’t pay your loan back, they still have a good chance of repossessing your house and selling it to get all of their money back. So, your loan is considered less risky to the bank.
If your loan has a LTV of more than 80%, the bank isn’t sure whether they could get all their money back or not in the event of a foreclosure, so they require you to take out PMI. If your loan goes bad and the bank doesn’t get all of their money back after selling your home, they get reimbursed by the company that sold you the PMI. So you can see that PMI is the bank’s insurance that your loan won’t go bad, which helps the bank reduce their risk on loans that are considered too risky.
Why PMI is bad
PMI is a bad thing for you to have, but it isn’t necessarily a bad thing to get in the first place, here is what I mean: There are a lot of bad things about PMI, but there is one good thing about PMI. The problem with PMI is that it is an expensive payment you must make every month, and it doesn’t do anything for you. PMI protects the bank, it doesn’t protect you. If your loan were to go bad the bank would get its money back, but you would still lose your house and have red marks all over your credit report.
The one good thing about PMI is that it allows you to buy a house when you otherwise wouldn’t have enough cash to qualify for a mortgage. I have PMI on my mortgage, and I knew what a large expense PMI would be but at the time I bought my house I felt like I was getting a good deal and all the advantages of buying my house when I did out weighed the advantages of waiting until I had enough cash to make a 20% down payment.
So even though getting PMI wasn’t necessarily a bad choice, I now consider the PMI my #1 financial enemy and am working hard to get rid of it. Why is PMI my # financial enemy? We all know that when you are trying to eliminate debt you should usually pay off your debts that have the highest interest rate first. You may not think of your PMI as having an interest rate, but it is fairly easy to calculate. When you do calculate your PMI’s effective interest rate I think the chances are pretty good that this will effectively be the highest interest rate you pay, and therefore the debt you want to get rid of first.
How to get rid of PMI
Although the rules can very slightly depending on what bank you use in general you have to pay your loan balance down until the LTV is 80%. Once you do this you must request that your bank remove PMI from your mortgage and your bank will perform a kind of mini internal appraisal to make sure the value of your house hasn’t gone down. If they determine it hasn’t gone down, then they take the PMI off of your mortgage and you no longer have to pay it each month. If they determine the value of your house has gone down (don’t be too surprised if their internal appraisal comes back unreasonably low), then you have the option of appealing that decision by paying about $400 for a full appraisal to be done. If the full appraisal comes back and shows that your LTV is 80% or less, then the PMI is removed.
If you don’t want to pay the $400 for a full appraisal to be done, you could pay your mortgage balance down to 78% LTV. At 78% LTV, PMI is removed from your mortgage automatically with no request required and no appraisal required. I would suggest you go ahead and request it anyway, just to make sure your bank is doing their job.
But how do you know if PMI should be your first priority when paying off debts?
Effective interest rate of PMI (you might want to skip this section)
If your not a nerd, just go ahead and skip this section. Its a bunch of math and it is much easier to just use the calculator I have put at the bottom of this article. Us nerds will catch up to you in the conclusion. Bye, we will see you later!
OK fellow math enthusiasts let’s have some fun! I like to think of PMI in terms of interest, because there is a payment we make monthly (like interest) that we can make go away if we pay down a certain portion of debt. To calculate the effective interest rate, simply divide your annual PMI payments by the amount you would need to pay your balance down in order to achieve a 80% LTV.
There is a good chance the effective interest rate you just calculated is a fairly high interest rate compared to today’s market. But, that isn’t the only advantage to paying down your mortgage balance. Remember that in addition to removing PMI, you also don’t have to pay interest on the portion of the balance you paid off. So to get the total effective interest rate you could save, add the effective PMI interest rate you just calculated to your actual mortgage interest rate to get the total effective interest rate you are paying. There is a good chance this effective interest rate is much higher than any of the rates you are paying on your other debts, so removing PMI would be your #1 financial enemy. As your balance gets closer to the 80% LTV level, this effective interest rate will skyrocket to a ridiculously high rate.
Here is a calculator to calculate just how much PMI is costing you:
If the effective total interest rate you just calculated is higher than any of the other rates you are paying on your other debts, then removing PMI should probably be your top debt reduction priority. If you can’t pay it off all at once, try to pay a little extra principle each month until you can get PMI removed. Once you have done this your mortgage payment will go down because the bank will stop making you waste money every month on the PMI payment.