PMI versus LPMI versus 1st trust/2nd trust Combo Loan

Everyone likes to think PMI (Private Mortgage Insurance) is evil. People like to think they should not have to pay it, and want to find a way around paying it. There are ways to work around PMI. But like all things in life, there are trade-offs. A person really needs to look at all the options and trades-offs, and consider how long they think they are likely to spend in their new home. Then everyone needs to consider paying PMI! What do I mean?

I mean that everyone needs to consider all options, even actually paying the PMI. Consider paying PMI versus LPMI. Consider a first and second trust combination loan. I will outline below the three possible scenarios. You can apply this to your own circumstances and decide for yourself what your best choice is.

You can drop your PMI at some point in the future

On a conventional loan with PMI you should take into consideration that you will have the chance to drop the PMI at some point in the future. The LPMI loan where the lender pays your PMI is not a gift from the lender. The PMI is built into a higher interest rate. The 1st and 2nd trust loan option is where you borrow 80% of the sales price on a 1st trust mortgage and 15% of the sales price on a 2nd trust mortgage. And then do your 5% down payment. This results in no PMI because the 1st trust lender is now only exposed to 80% of the risk and does not require PMI as a result.

Assumptions

The base assumptions I will use are below:

• Sale price of new home is $400,000
• 5% down payment
• $380,000 mortgaged amount
• Property type is single family detached
• Credit Score of buyer is 740
• 0 discount points being paid on the loan
• 30 day loan closing
• Interest rates will be discussed in each example
• I will not itemize property taxes or homeowners insurance since the type of financing does not affect those two monthly expenses

Paying PMI

• $400,000 sales price
• $380,000 30-Year Fixed Rate loan
• Interest Rate 4.5% (Used for illustrative purposes only)
• $1,925 principal & interest mortgage payment
• $196 monthly PMI
• $2,121 total mortgage and PMI payment

LPMI (Lender Paid Mortgage Insurance)

• $400,000 sales price
• $380,000 30-Year Fixed Rate loan
• Interest Rate 4.875% (Used for illustrative purposes only)
• $2,010 principal & interest mortgage payment
• $0 monthly PMI
• $2,010 total mortgage and PMI payment

80-15-5 1st trust/2nd trust combo

• $400,000 sales price
• $320,000 1st trust 30-Year Fixed Rate loan
• $60,000 2nd trust Interest Only, Adjustable Rate loan
• Interest Rate 1st trust 4.625% (Used for illustrative purposes only)
• Interest Rate 2nd trust 5.25% (based on Prime Rate + 2%) (Used for illustrative purposes only)
• $1,645 principal & interest mortgage payment 1st trust
• $262 interest payment on 2nd trust
• $0 monthly PMI
• $1,907 total mortgage and PMI payment

Conclusions

Based on the above, there is no discussion. You take the 1st trust/2nd trust combo because it has the lowest payment, correct? Wrong! First, you need to think through your appetite for risk. Some people may not like the fact that the 1st trust/2nd trust combo loan has a 2nd trust that does not pay down principal and has an adjustable rate mortgage. You can pay principal down on the loan, if you choose, with no penalty. However, the 2nd trust is set up to only require interest payments. So while you are paying the lowest monthly payment each month thanks to the Interest-Only 2nd trust, that payment may adjust upwards. And you are not paying that mortgage down. Are you robbing Peter to pay Paul, as they say? You decide.

Most importantly, you really need to think through how long you expect to be in the home. And what if you may keep it as a rental property when you move out? Think those things through and then decide. Here are some examples of other ways to look at the above scenarios. This is best besides strictly looking at which option has the lowest monthly payment.

If you think you will be moving out of the home after 7 years elapses, then consider the below:

LPMI:

With this loan you are locked into the higher rate that it took to get the lender to zero out your monthly PMI payments. So your total payments over 7 years are $2,010 x 84 = $168,840 total mortgage cost.

1st trust/2nd trust combo:

With this loan, you are locked into the adjustable rate 2nd trust. And to be fair in assessing the numbers you’d have to build in a guesstimate for the 2nd trust payment to go up. You would also have to factor in that you would owe more on the 2nd trust after 7 years since you would not be paying down principal. Had you put that $60,000 from the 2nd trust into the 1st trust mortgage at 4.50% you would only owe $52,215 on that portion of the loan after 7 years. That is $7,785 in extra principal you owe on the 2nd trust if you move in 7 years. And that equals $92 a month! So after 7 years on the 1st trust/2nd trust combo loan you may have paid:

• $138,180 on the 1st trust in total payments ($1,645 x 84)
• $22,008 on the 2nd trust assuming Prime rate never changes ($262 x 84)
• $7,785 in extra principal you’d owe on the 2nd trust gets factored in.
• $167,973 total mortgage cost

This is almost equal to the LPMI total cost over 7 years, assuming zero rate increases over 7 years!

PMI:

The loan with PMI gets a bit more complicated to ascertain the total cost of over 7 years. This is so because you may drop the PMI at some point. In paying PMI your total monthly payment may be as below:

Year 1: $1,925 mortgage + $196 PMI = $2,121 x 12 payments = $25,452
Year 2: $1,925 mortgage + $196 PMI = $2,121 x 12 payments = $25,452
Year 3: $1,925 mortgage + $196 PMI = $2,121 x 12 payments = $25,452
Year 4: $1,925 mortgage + $196 PMI = $2,121 x 12 payments = $25,452
Year 5: assume a PMI Drop.” $1,925 mortgage + $0 PMI = $23,100
Year 6: $1,925 mortgage + $0 PMI = $1,925 x 12 payments = $23,100
Year 7: $1,925 mortgage + $0 PMI = $1,925 x 12 payments = $23,100

$171,108 total mortgage cost

You may drop PMI by paying the principal down to the required loan-to-value instead of waiting for it to happen by the regular amortization of the loan. If you want to remove the PMI through appreciation of the home you typically must wait 2 years and have an appraisal done. What if you get an appraisal done and the appraisal is not quite high enough to meet the required loan-to-value? You can always pay the loan balance down so that it meets the loan-to-value requirement of the recent appraisal.

PMI Drop: getting rid of your PMI at some point

In thinking through the PMI Drop portion of this discussion, you need to estimate what you think the annual appreciation rate will be. There is a website I have used to help with this, NeighborhoodScout.com. You type in your city and state and hit enter. You will find data on schools, crime rates, and appreciation rates, which is the data we want for this discussion. Click on the “Appreciation Rates” tab to get an idea of the long-term appreciation rates in your market. The data goes back as far as 1990, which is almost a quarter century of data.

On the loan with PMI after 7 years you would owe $353,750. To achieve an 80% loan-to-value you would need the home to appraise for $442,187. To achieve a 75% loan-to-value the home would need to appraise for $471,666. You should ask your lender what the PMI Drop requirements would be if you take a loan with PMI.

Assuming the above, you would need a little less than 3% appreciation each year to achieve an 80% loan-to-value, and hence a 20% equity position. Three percent exactly each year would take you to a $450,200 valuation, which is above the $442,187 needed to show 20% equity. You would need a little over 4% appreciation per year to achieve a 75% loan-to-value in 4 years. Four percent exactly each year takes you to a $467,942 valuation. So you’d need a bit more to achieve the $471,666 valuation needed for a 75% loan-to-value, and hence a 25% equity position.

Bottom line

The bottom line is that there is a lot to think through to make an educated decision. You may want to pay PMI versus LPMI options. Instead of making a knee-jerk reaction to choose the loan option with the lowest monthly payments, work with a lender that will carefully analyze all options.

Schedule a call with me to talk about how options like these might apply to your situation.