As part of my housing search, I have been bombarded with financing options. And just as soon as I decided I wanted a 30 year fixed mortgage, I was bombarded with yet another set of options: borrower paid PMI, lender paid PMI, or piggyback loan. Despite being independent of the down payment, these options could potentially change my monthly payments by hundreds of dollars a month, and total money paid (in the end) by tens of thousands! So what are the in’s and out’s of each?

First off, these options only exist because I am not putting at least 20% down. Afterall, who can afford that? So because I am not putting 20% down, the lender needs something else to assume this higher risk. One form of that is private mortgage insurance (PMI). Exactly as it sounds, this is an insurance policy so that if I default on my mortgage, the lender (the bank) will still get money (from this insurance company). PMI comes in two flavors — borrower paid (me) or lender paid (the bank). But don’t worry, the bank will get it out of you one way or another! The third option which avoids PMI is a piggyback loan situation. This situation actually creates two loans, such that the primary loan is no more than 80% of the home’s value (hence avoiding PMI). But, of course, the second (piggyback) loan will be at a higher rate since it does not have first dibs (lien) on the house if I default.

  • Borrower Paid PMI: Borrower paid PMI is probably the simplest option to understand. Say I put down 10% on a home, my mortgage will cover 90% of the home value. Being more than 80%, PMI is required. Borrower paid PMI means that I pay a monthly premium (usually around one or two hundreds dollars) in addition to my monthly house payments. If you use an escrow account, this PMI payment would be folded into the escrow. PMI is expensive and no one is ever happy to pay for someone else’s (the bank’s!) insurance. However, there is an advantage. The good thing about borrower paid PMI is that once your loan is no longer greater than 80% of the home’s value, you can drop the PMI payment! This can happen if your home appreciates enough or if you pay down enough of the principle. Note, if you try to cancel PMI because your home has appreciated, you’ll need a reappraisal which may cost several hundred dollars. Of the three options here, this is usually the most expensive in terms of monthly payments initially, but since you get to eventually drop the PMI, the total cost over the life of the mortgage may be the cheapest.
  • Lender Paid PMI: Another way to finance PMI is to have the lender pay it! Sounds great, right? Well, it comes at a cost. The lender will charge you a higher rate on your mortgage to do this — maybe around 0.25% or 0.5% higher. So, you as the borrower completely avoid ever having to deal with PMI, but your entire mortgage will be at a higher rate. From my minor experience, I’ve found this results in cheaper monthly payments than borrow paid PMI, however, you can never “cancel” the higher rate even if your mortgage eventually becomes less than 80% of the value of the home. That higher rate is fixed for the life of the loan! Hence, while the initial monthly payments are cheaper than borrow paid PMI, they will eventually be higher when the borrower paid PMI would have been cancellable. The glaring question is… assuming you can afford the higher monthly payments initially, how long does it take until you can cancel the borrow paid PMI? Unfortunately, you’re going to have to run the numbers yourself to answer this one, as it depends on how much you pay each month and the appreciation of the home. A rough calculation using dinkytown’s calculator shows it maybe around 6 or 7 years (though this is highly situationally dependent).
  • Piggyback Loan: The last option is called the piggyback loan. Here, there is a primary loan that is 80% of the value of the home. This is the standard loan. The, a second loan is created to assume the rest of the debt. This is called the piggyback loan. It can commonly be in the form of a home equity loan (HEL) or a home equity line of credit (HELOC). This secondary loan is constructed such that in the case of a default, the primary loan has first rights (first lien) on the property. Therefore, the piggyback loan is much higher risk, which translates directly to a higher interest rate for the borrower. This rate maybe around 2% higher than the primary loan. This higher interest rate makes that second loan costly, but the good news is you can focus extra housing payments directly on that loan and pay it down faster. Also, usually interest on the piggyback loan is tax deductible, where as PMI may or may not be. My minor experience has shown that the piggyback loan monthly payments fall somewhere between the borrow paid and lender paid PMI options.

To summarize, there are three different ways to finance mortgages higher than 80% of the value of a home, each with their own twists. Of course, you really need to run your own situation to find out exactly which one is best for you! Your credit score, down payment amount, income, and tax bracket will all affect the results. Also, the tax deductibility (a future post to come this week) of PMI affects this greatly too. But probably most importantly, the time line of how long you may keep the home (more specifically, the mortgage) affects the decision. Remember that refinancing is always an option, though it is not cheap and interest rates will undoubtedly change (up or down, who knows!). Of course, your budget my dictate which option to take, as the monthly payments associated with each is different. So as with anything else financial, it is important to run your own numbers and analyze your own particular situation. And don’t worry, your mortgage lender should be there help you through the process. Hopefully this post gives you the right questions to ask!