Why paying off PMI should be a top financial priority

Private mortgage insurance (PMI) can be a good thing when you are trying to get a mortgage, but once you get that mortgage everything changes.  In most cases, once the mortgage is signed, PMI becomes your number one financial enemy and should be eliminated as soon as you possibly can.

What is PMI?

PMI is a tool that allows banks to make mortgage loans to people who have a down payment of less than 20% of their home’s value. Borrowers will less than 20% might otherwise be considered to be too risky to lend to. So PMI is basically insurance that is paid for by the consumer to cover the bank against the risk of default.

By paying PMI you are reducing the bank’s risk. That is a good thing for you because it allows banks to make loans they otherwise may not have made. And they are able to make them at lower rates than they would have offered without mortgage insurance.

The downside of PMI

The problem with PMI is that it is expensive and comes with an effective interest rate that is likely much higher than your other debts. To illustrate how expensive PMI is compared to your other debts let’s look at a recent caller to the Clark Howard Show.

A caller named Miles recently asked how he should allocate his money each month between paying off debts, building up an emergency fund and contributing money to a Roth IRA. Miles told Clark that all his debts were at a rate of 6% or below, that he had purchased a house last year and that the mortgage has PMI on it. Clark’s advice was to split his extra money each month between paying off the 6% student loans he had, putting money into savings and putting money into a Roth. I’d like to explain why putting money towards the mortgage and getting rid of PMI could have been a better move with that excess cash.

The real cost of PMI

There were some critical facts not discussed on the call so we are going to have to make some assumptions to show how much more money Miles would have saved by paying off PMI first.

According to Zillow, the median home price in the United States is about $185,000 so let’s pretend that is the value of Miles’ home. Since we know Miles wasn’t able to put down 20%, we will assume he has 10% equity and he needs to pay down another $18,500 before his balance is low enough he can ask his bank to take the PMI off.

According to the PMI calculator over at GoodMortgage.com, this would give Miles a monthly PMI payment of about $85. So if Miles paid his mortgage down by $18,500 he could save $85/month. That may not be the same thing as interest, but it sounds very similar to interest, doesn’t it?

Saving $85 per month by paying off a debt of $18,500 is sort of the equivalent of paying off a debt with a rate of 5.51%.  We will call this the effective interest rate.

Saving the effective interest rate of 5.51% isn’t the only advantage of paying down your mortgage, you also save money on the principal amount you paid off. If we add a mortgage rate of 4% to the effective interest rate of 5.51% that means Miles would save a total effective interest rate of 9.51% by paying his mortgage down to where he can get rid of PMI. That is a much higher rate than the 6% student loans he has outstanding.

So should paying off PMI be your top financial priority?

I made a lot of assumptions here, but in many cases for those that don’t have high interest credit card balances, PMI really should be a top financial priority. And it’s something most homeowners don’t consider.

If we had assumed a higher monthly PMI payment or a lower payoff amount the effective interest rate would have been higher, maybe even much higher. If we had assumed a lower PMI payment or a higher payoff amount then the effective interest rate would have been lower, but it is unlikely the total effective interest rate would have dipped below 6%.

To figure out if you should make paying off PMI a priority you need to know what your effective interest rate is.  To help you out with this, you can use the PMI effective interest calculator at ArtofBeingCheap.com.