If you've ever bought a home, or are looking to buy a home in the near future, you're probably familiar with PMI, or private mortgage insurance. PMI is protection for the lender or bank in case you stop paying your monthly mortgage payments. Usually, if you pay less than 20% of the purchase price up front, as a down payment, the bank will require an additional PMI payment each month.
If you pay for 20% or more of the purchase price up front, banks feel comfortable that you will try harder to make the regular mortgage payments, since you don't want to risk losing the money you put down if they foreclose on you. If you only put 5% down however, the banks feel like you're completely willing to lose $10,000 or $20,000 like it's nothing, so they require you to pay for the extra insurance to protect themselves.
So paying 20% down and avoiding PMI at all costs must be the way to go right? It's actually not that simple. If you're putting large amounts of money into the home you live in, you're missing out on the opportunity to invest in other assets, which might provide a better return like the stock market. In this article I'll walk through a few different examples comparing home purchases with and without PMI to see how it can impact your money.
All of these examples will use a 30 year fixed rate mortgage with 4% interest. Home appreciation is estimated at 3% annually, and any savings, or difference is invested with a 7% annual return.
Example 1: Single family home or condo
This example is as straightforward as it gets. Same house. Same price. Just different down payments and monthly payments. Nothing else changes but the amount that's left to invest.
Purchase price: $180,000
Total down payment: $36,000
Monthly principle and interest: $687
Total expenses: $36,000+$247,320= $283,320
Total equity: $436,907
Difference in monthly payment: $237
Invested monthly difference (30 years): $268,646
Net Gain: $422,233
Total down payment: $9,000
Monthly principle and interest: $816
~48 months of PMI ($5,184 total)
Total mortgage payments: $293,760
Total expenses: $307,944
Invest difference in down payment (30 years): $205,530
Invest PMI payment amount (last 26 years): $89,004
Home equity: $436,907
Total Gain: $731,441
Net Gain: $423,497
Winner: Draw, with a slight edge for PMI
The first example is extremely close, but I'd lean towards the lower down payment and PMI. I would rather have an extra $27,000 today, than spreading it out over 30 years of mortgage payments. Besides, due to inflation, $27,000 in 2020 dollars could have the same buying power as $57,000 30 years from now. All things being equal, I'll take the money now.
Example 2: Save up or scale up
This example compares 2 options with the same total down payment over a 3 year span, but in option 1, the owners save up for 3 years to put 20% down on one home, and in option 2, the owners purchase 3 homes over a 3 year span and hold on to them over the next 30 years, renting out the first 2 homes without ever increasing the rent prices.
Save up for 1 home over 3 years
Purchase price: $255,000
Total down payment: $51,000
Monthly principle and interest: $974
Monthly Savings (compared to option 2): $772
Monthly savings invested (30 years): $875,084
Home Equity: $618,951
Total gain: $1,494,035
Total expenses: $350,640
Net Gain: $1,143,395
Buy 3 homes in 3 years
5% down on each home
Purchase price: $340,000 each
Down payment: $17,000 each ($51,000 total)
Monthly principle and interest: $1,542
~48 months of PMI ($29,520 total)
Invest PMI payment amount (last 26 years): $506,832
Additional closing costs: $5,000 (total)
Rental income: $2,500/month
Rental expenses: $200/month
Mortgage payments (33 years): $1,665,360
Total expenses: $1,902,080
Total gain (3 homes, 2 with rental income): $4,947,656
Net Gain: $3,045,576
Winner: PMI by a wide margin
This is an excellent way to scale up your homes very quickly, and a strategy that my wife and I have actually used before. As you can see, after 30 years there is almost a $2 million difference. The keys here are that you need to buy and hold for a long time, and you need to be able to your home out to cover the mortgage and future expenses. It's difficult to buy and sell a house each year, because it eats up a lot of money in closing costs. The renting can be tight in the first year or two, and your margins might be thin, but unlike this example, in the real world the rents are likely to increase in the future, which can provide even larger returns.
Example 3: Find a Great Deal
This example is my favorite one. I love a great deal, and in a perfect world I would combine it with the previous example and do it every year but I think my wife would kill me if we moved every 12 months. Here we'll need to buy a home 20% below market value, and then refinance out of the PMI in 18 months. If we're not putting more money into the property with major renovations, we'll likely need to wait at least a year in order to refinance, so let's say we found this deal in the winter, when home prices are lower, then refinanced out in the summer (18 months later), since that's when the market is the hottest and prices are generally higher.
Purchase Price: $290,000
Home Value: $350,000
Total down payment: $58,000
Monthly mortgage: $1,108
Monthly savings: $381 for first 18 months, then 207 for remaining 342 months
Invest Monthly Savings: $249,242
Home equity after 30 years: $849,541
Total expenses: $456,880
Net Gain: $641,903
Purchase price: $290,000
Home value: $350,000
Total down payment: $14,500
Monthly principle and interest: $1,315
~18 months of PMI: $3,132 total
Invest down payment savings & PMI payment amount (30 years & 28 years): $499,628
Home equity: $849,541
Total expenses: $491,032
Total gain: $1,349,169
Net Gain: $858,137
Again, the clear winner is putting 5% down and paying a little bit of PMI. This is another strategy that I've used in the past, and is a great way to get into a nicer home for your family without breaking the budget. It just requires an excellent knowledge of the home prices in your area, and massive amounts of patience. I've been watching every condo that's sold in our neighborhood within our budget for over 3 years now. It can take time to find a great deal, especially if you're relying on the MLS.
As you can see, PMI is nothing to be afraid of, and in many cases could actually be a better use of your capital than a 20% down payment. Just remember that in each of these examples, the difference in down payments was invested, and the amount used on PMI was saved and invested after the PMI was paid off. The important lessen is not to wait to invest. Time can be the greatest asset when working with compound interest, so don't wait to get started. The sooner you can get invested, the better off you'll be.