At first glance, private mortgage insurance (PMI) may seem to be more of a negative than a positive for homebuyers. Although mortgage lenders’ willingness to accept private mortgage insurance as a loan guarantee means that homebuyers who can only pay a small percentage of the loan up front will be able to afford homes, it also means an extra monthly premium for these individuals until they are able to reach 20% equity in their homes. However, mortgage insurance may be a desirable option in many cases when compared to the alternative ― a higher mortgage rate on the loan.
When you agree to accept a higher-than-required interest rate in order to avoid paying mortgage insurance, your lender uses the extra interest to purchase private mortgage insurance for themselves on your loan, for a lower rate than you would be charged for the same insurance. This protects the lender in case you default on the loan.
Keep in mind that you will have to pay interest on the loan until the entire loan is paid off, while you will only be required to pay private mortgage insurance until you have paid the loan down to 78% of its original value (or 80% if you request termination at that point.) This makes private mortgage insurance a more attractive alternative for many. However, mortgage interest is tax-deductible, while private mortgage insurance payments are not.
To figure out which option will save you more money in the long run, calculate factors such as how long you plan to be in the house. If you plan to occupy it for only a few years and then sell it, you may want to take the higher interest rate in order to maximize your tax savings. This goes for individuals in a high tax bracket, as well.
How great is the increase in mortgage interest that your lender is offering in lieu of private mortgage insurance? If it is only increased enough to offset your lender’s own mortgage insurance costs, it may be a worthwhile deal.
Finally, if you expect your property to appreciate in value in the near future (due to home improvements or external factors in the neighborhood) that might tip the scales toward accepting private mortgage insurance instead. The reason is that property appreciation increases your equity in the home, allowing you to get closer to that all-important 20% that will allow you to cancel your private mortgage insurance.