Private Mortgage Insurance (PMI) is a payment required by mortgage companies when you are asking for a loan greater than 80% of the assessed value of the property. PMI can add thousands of dollars to the cost of purchasing a home. Avoiding PMI, if possible, is better for your long term finances. Here are three strategies to avoid PMI.
The most common method of avoiding PMI is to provide a 20% down payment in cash at the time of purchase. In order to have this cash available, you most likely need to save for this goal in advance.
Continuing with our example of a home valued at $200,000, the amount you need to save for a down payment is $40,000. If the markets are making 5% in returns, then over the course of 5 years you will need to save $589.85 each month. After 5 years , your savings will have grown enough to cover the down payment and you will be able to purchase your new home and secure a mortgage without having to also get PMI.
Investing your savings exposes your down payment fund to market fluctuations. If you prefer not to invest your savings you would need to save $666.67 each month to make up for the lack of an expected 5% return.
Saving in advance of your purchase requires discipline and planning. Young people would do well to start saving at least 15% of their take home pay as soon as they have their first job.
A second option is to purchase a new home and save for the down payment after the purchase.
This option assumes that you have a friend or family member who can provide you a personal loan for the cost of the down payment. If you have saved enough to cover 10% of the down payment, you could ask a friend to loan you the remaining 10% value of the home, in our example, $20,000. You would then pay that friend back in the form of a loan. If you paid them over the course of 5 years at an estimated 3.22% interest rate, you would be making payments of $361.33 to your friend each month.
If you had to borrow the entire $40,000 for the down payment from a friend, you would owe them $722.66 each month, assuming the same interest rate.
Saving for the down payment after the actual purchase occurred is not as efficient as saving for the down payment prior to purchase. Saving after the fact and paying interest costs $722.66 each month, while saving and investing ahead of time only costs $589.85. Nevertheless, saving after the purchase is still a much better option than PMI.
Pledged Asset Account
A final option is to open a pledged asset account. This would allow you to pledge investment assets, such as securities, as collateral against the loan. The pledged asset account must hold assets equal to 30% of the value of the home. If the markets drop and the value of the accounts falls below 30% of the value of the home, then you will need to add additional assets to the account in order for it to meet the required value.
A pledged asset account allows the assets to stay invested in the markets, rather than having to liquidate assets and potentially realize capital gains in order to have enough for the down payment.
However, if you default on your mortgage payments, you risk not only the possibility of losing your home, but you risk losing the assets pledged as collateral as well.
Interest rates for mortgages are currently much lower than expected market returns. In other words, you should be able to make more by having your money invested in the markets, where it can continue to appreciate, than you would pay in interest on your mortgage payments. Because of this, choosing to open a pledged asset account could not only be a means of avoiding PMI, but it could also be a strategy which is superior to paying for the down payment in cash.
Purchasing a home is a large financial undertaking. If you don’t have enough funds for a down payment, it may seem like PMI is your only option. But it is good to keep these more creative ways of avoiding a down payment in mind. They can provide a much less expensive method than PMI to purchase a home.
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