Avoid PMI at All Costs?

"My wife and I are preparing to finalize on our home mortgage but the final appraisal did not end in our favor.  Unfortunately, this puts us in a 90/10 loan bracket with PMI (Private Mortgage Insurance).  We could pay the difference of the loan to appraisal value from our savings to get to an 80/20 loan with a slightly better interest rate and no pmi.  The downside is it would use a lot of our savings to accomplish this.  Any suggestions?"  

I’m sorry to hear that, but this is often an issue with building a new home especially if you have put a lot of upgrades into the house (i.e. granite countertops, upgraded appliances, fixtures, and flooring).  I’m not saying don’t put those things into your new home, just be aware that if you do, it may not appraise out.  I also have to say congratulations that you and your wife have enough in savings to potentially cover the extra 10% on top of the 20% you already budgeted.  There are many people who would not be in the position to even consider these two options.

As far as your question is concerned, there are two distinct ways of looking at this.  The first is from a philosophical standpoint.  Some people will look at PMI and a higher interest rate and say, “I do not want to waste my money and pay PMI if I do not have to”.  In most cases, that is probably also going to be the most financially sound way of looking at your decision.

The other way of looking at this is strictly from a financial perspective.  There will be numerous variables to consider so I won’t be able to give you an exact answer here.  What I will do is point out several things you should consider.

The most important is where are you drawing the extra 10%?  If this is sitting in cash, then you have little to worry about.  However, if you have to sell existing investments at a gain, then you will also be paying tax on the gain at either the long or short term rate.  Of more significance would be if you are withdrawing money from a traditional IRA or 401(k).  This could really impact you, not just with the tax hit on the entire withdrawal but potentially a 10% penalty as well.  These impacts along with the loss of potential tax deferred growth could be significant.  You could also be borrowing from a 401(k) if your plan allows it but you need to make sure you understand all the details behind this.  Failure to comply with all the rules may result in treatment of the loan as a withdrawal and thus be subject to the same concerns expressed above.  Finally, if you withdraw it from a Roth IRA, you won’t have to pay a penalty or tax on the withdrawn amount up to your basis, but you do lose out on all the tax free growth.

The next item to consider is what is your expected return on the 10% if you left it invested.  It is possible that your expected return would be high enough by itself to justify PMI and the higher interest rate.  This is probably not going to be the case, but it is something that must be considered.

Next, decide what you would most likely do with the money that you save month after month if you opted to make the additional down payment.  Since you appear to be “savers”, my guess is that you would continue to save the money and not spend it.  If this is the case, then you need to determine where it would be invested and the expected rate of return of that.  If it would regularly be invested in the same way as the 10% is currently invested, it probably makes sense to make the additional down payment and avoid PMI.  If it is difficult for you to save the difference between the two mortgage payments, then you may be better off keeping your 10% invested.

Finally, consider if the extra 10% is earmarked for something else.  Perhaps it is a vacation, a new car, children’s education.  How would spending this money on the house impact those future purchases?

I am sure you have probably considered a lot of these items already.  Maybe you have already done some of the math yourself.  Whatever the case, a good fee only financial planner, can assist you with this process and can assist you in answering this question from strictly a financial perspective.  More often than not, the likely conclusion is to make the additional down payment and avoid the PMI.  I hope this helps and congrats on your new home!