I’ve mentioned a few times that we bought our house with only 10% down and are currently paying Private Mortgage Insurance (PMI) on a monthly basis. The PMI was necessary to get the loan because we didn’t have the standard 20% down payment required to get a traditional, non-PMI insured, mortgage loan. One of our major short-term financial goals is to get rid of the PMI by making extra payments towards our mortgage principal. Once we reach the standard 20% equity in our house, we can contact the mortgage provider and then completely remove that part of our payment for the rest of the loan (most likely after a new assessment of the property). The PMI is purely a price paid for taking out a loan with less than 20% and provides no long term value to us, so removing that expense would permanently reduce our monthly expenses. A recent comment asked why getting the mortgage up to 20% asap was a priority and I thought I’d take this chance to dive into the math and see what kind of return is possible by throwing extra money at a mortgage with PMI.
Some Average Numbers
In order to calculate what kind of return paying extra on a mortgage with PMI gets, it’s easiest to talk about if we have some numbers to work with.
Here’s some run of the mill numbers to get us started:
- Home Cost: $200,000
- 10% down payment: $20,000
- Initial Mortgage Loan Amount: $180,000
- Mortgage Interest Rate (30 year): 4.00%
- PMI Monthly Payment: $75 (or 0.5% of the initial loan amount)
In this example, I chose the numbers arbitrarily, but they closely reflect what you will commonly find in today’s mortgage market. Interest rates are in the 3.5-5% range depending on a number of factors, and PMI tends to range from 0.3-1.5% of the original loan amount. Most mortgage contracts allow you to drop the PMI upon reaching 20% equity, or in this case, reducing the principal loan to $160,000 by making a total of $20,000 in payments towards the principal (including standard and extra payments).
Looking at a standard loan amortization schedule (fancy term that describes handling the principal in interest in equal payments for the entire course of the loan), the monthly payment for this mortgage comes out to $859.35 for just principal and interest. Most mortgage payments also include an escrow that pays insurance and taxes, but we’ll ignore that because that money has to be paid whether you have a mortgage or not.
First, Let’s Look At No Extra Payments
If you decide to just make the standard minimum payment every month on the mortgage, it will take almost 6 years to reach 20% equity naturally! That’s 68 monthly mortgage payments that include a $75 PMI “fee” for a total of $5,100, just for the privilege of getting the loan in the first place. Now there are certain circumstances where putting less than 20% down makes sense (I think we made the right choice), but in general it’s probably best to avoid paying thousands of extra dollars if you don’t have to.
What About Paying It Off Immediately
Now let’s look at the other extreme and pretend that right after you took out a loan with only 10% down, you happened to find another 10% ($20,000 in our example) lying around. Should you immediately pay down the principal to 20% or does it make sense to chase potentially higher gains elsewhere? Keep in mind that removing the PMI with an instant payment is a completely tax-free, guaranteed return on investment.
First off, making ANY extra payments towards mortgage principal are essentially guaranteed gains at exactly the interest rate of your loan. Traditional mortgages calculate interest monthly, so you will almost instantly start saving money on interest by making extra payments towards principal early. While your monthly payment won’t go down, more of each payment will go towards the principal and the length of the loan will shrink accordingly. That extra $20,000 payment in our example will drop almost 6 years off of the 30 year mortgage and save ~$38,678 in total interest payments over the course of the loan!
In addition, we will also save the $75 per month in PMI we would have paid over the 68 standard payments it would have required to get up to 20% equity! At $900 per year, that’s an additional 4.5% return per year on our $20,000 “investment”!
In total, we end up getting a 8.5% annual return on our $20,000 investment over the course of the first 5.67 years of the mortgage. After that point, the PMI would have been removed anyway and the money will continue to get a 4% return for the rest of the length of the mortgage via saved interest.
Tax-free, guaranteed 8.5% returns! That’s going to be difficult to beat on any consistent basis (especially over 5+ years) so I would argue it’s a no-brainer to put that money towards the mortgage to immediately remove PMI.
4.5% Returns By Eliminating A 0.5% PMI payment? What?!?
At first glance, you might think the calculation was wrong if we ended up with a 4.5% effective return by eliminating a 0.5% PMI payment. The trick is that the 0.5% PMI is on the entire loan amount of $180,000, NOT 0.5% on the $20,000 required to eliminate it! $20k is 1/9 of $180,000, thus the actual return can quickly be calculated by multiplying the rate (0.5%) by the fraction of total loan amount over amount required to eliminate it ($180k over $20k = 9) to get the same 4.5% we calculated above.
Remember, this is in addition to the 4% returns obtained naturally by making extra payments towards a loan with an interest rate of 4%.
The numbers get even crazier if we talk about lower initial down payments and higher PMI rates. For example, putting 5% down with a PMI rate of 1% would equal extra returns of 6.3% (total of 10.3% if we assume the same 4% loan) if you could instead start the mortgage with a traditional 20% down payment.
In other words, don’t take out a loan with PMI if you don’t have to!
How About Somewhere In The Middle
What about the more likely example of having a little extra left over each month to either put towards PMI or invest in a taxable account? (I won’t get into PMI versus tax-advantaged accounts, but you should definitely max out your employer match first regardless of whether or not you have PMI. After that, it will be a slightly different calculation versus the one below on tax-advantaged versus extra mortgage payments).
Let’s say after adding up all of your expenses and the money you’re putting away in tax-advantaged accounts like 401k’s and IRA’s, you have an extra $500 per month. Should you put it towards the mortgage in the form of extra principal payments or invest in broad-market index funds via a taxable brokerage account?
By adding the $500 surplus to our monthly mortgage payment, we can actually get up to 20% equity and remove PMI after just 25 payments! That means we would save the $75 PMI payment for each of the remaining 43 payments it would have taken to remove the PMI naturally, for a total savings of $3,225. With the additional $2,375 saved in interest, the total return for making 25 extra monthly principal payments of $500 comes out to $5,600 over the course of 68 months.
If we would have taken those extra $12,500 in principal payments and invested them in a taxable account instead, where would we be at after 68 months? By compounding an average return of ~6.17% annually on a monthly basis (0.5% per month), the investment would be worth $16,620.97 at the end of 68 months for a total gain of $4,120.97.
The $4,120.97 in gains is less than the $5,600 saved by making extra mortgage payments over the same time frame AND will potentially be taxed as capital gains when withdrawn! If you expect to receive ~6% annual return on your outside investment, it definitely makes sense to instead take the guaranteed return of paying off the PMI early!
What if you expect better returns? To break even on gains versus amount saved, you would need to get 7.8% returns BEFORE taking into account taxes. If you assume a 15% capital gains tax, you will need to get an almost 9% return just to break even versus the extra mortgage payment strategy!
These return numbers certainly aren’t crazy considering the S&P 500 has returned close to 10% per year since inception, but you have to keep in mind that the returns from paying off the PMI early are guaranteed and tax free!
Calculating Your Own Payoff Rate
The actual return you can expect to get from making extra mortgage payments to remove PMI will vary depending on what % of the loan amount your PMI is (the example used 0.5% annually) and how much extra you are able to contribute towards it each month. You will ALWAYS get a return equal to your interest rate for the life of the loan PLUS an additional “return” for removing PMI earlier than you would have naturally.
I worked backwards using amortization tables and excel to obtain the various numbers above, but maybe someone smarter than me can come up with a slick formula to calculate exactly how different extra monthly payments translate into effective return on investment. It will always end up somewhere between your overall loan rate and the maximum return calculated above of:
Loan Rate + PMI Rate * (Total Loan Amount / Payoff Required)
Two Birds With One Stone
In our case, we decided the benefits of eliminating PMI out-weighed putting extra investments in taxable accounts and have been making extra payments on the loan since we got it. In addition, my year end bonus actually puts us in a situation where it’s possible to make a large lump-sum payment to get up to 20% equity right now! As removing the PMI with our current loan provider would require an assessment anyway, we thought we’d look into refinancing our entire mortgage at the same time.
One of the larger costs of refinancing is the assessment, which we would pay anyway to remove PMI, so why not see if we could reduce our interest rate at the same time? Interest rates have fallen about half a percent in WA since we got the loan about a year and a half ago, so trying to lock in a lower rate probably makes sense despite the costs that go into refinancing. A quick calculation shows we’d make up the cost of the refinance in a fairly short period of time.
After some back of the napkin math showed it made sense, we looked a little deeper, called around for some quotes, and are amidst the refinancing process as we speak. Assuming the assessment comes back as expected, it looks like we’ll be able to knock ~$350 off of our monthly payment thanks to the combination of eliminating PMI and reducing our interest rate at the same time!
Stay tuned to future posts to see exactly how a bunch of new credit cards on each of our credit reports impacted our interest rate! (Hint: It wasn’t a zero impact)