REAL ESTATE TOPICS...MIP, PMI, or neither?

Default insurance for mortgages with loan-to-value ratios (LTVs) exceeding 80% comes in two forms:

• mortgage insurance premiums (MIPs), as required by the Federal Housing Administration (FHA); or
• private mortgage insurance (PMI), available from private insurers.

The rate of default insurance premium and the underlying interest rate vary depending on the LTV.

The MIP rate for an FHA mortgage with a 3.5% down payment remained at 0.85%, while the PMI rate for a similar mortgage with 5% down payment remained at 0.89% in the second quarter (Q2) of 2015. The MIP rate for 30-year FHA mortgages decreased in January 2015 from 1.35% to its current 0.85%, while PMI rates have remained unchanged since they decreased slightly at the end of 2013. The result of the MIP decrease makes FHA-insured mortgages slightly less expensive for buyers than a similar mortgage with PMI.

Today, fixed-rate mortgage (FRM) rates are slightly lower than rates one year ago. Thus, homebuyers are qualifying to borrow slightly more mortgage funds, their purchasing power increased due to decreased long-term mortgage rates. However, home sales volume won’t gain traction yet, as buyer purchasing power will reverse direction when FRM rates rise, now expected in mid- to late 2016. Home prices will rise only slightly between now and the FRM rate rise, to reverse direction 9-12 months after FRM rates begin an on-going increase.

Updated 09/08/2015. Original copy released 08/30/2011.

Chart update 09/08/15

Mortgage Type and Term	Average MIP/PMI
30-Year FHA Mortgage (LTV > 95%)	0.85%
30-Year FHA Mortgage (LTV ≤ 95%)	0.80%
30-Year PMI Mortgage (LTV 90.01-95%)	0.89%
PMI Mortgage ≤ 25 Years (LTV 90.01-95%)	0.81%
15-Year FHA Mortgage (LTV > 90%)	0.70%
15-Year FHA Mortgage (LTV ≤ 90%)	0.45%

This chart tracks the total percentage rate paid on principal for mortgage default insurance (mortgage insurance) paid by homebuyers who make a down payment of less than 20% of the price they pay for a home, including premiums and interest due on 30- and 15-year FRMs.

Editor’s note – Since low-down payment conventional mortgages with PMI typically come with higher mortgage rates than FHA mortgages with MIP, an addition of 0.63% has been added to the conventional 30-year FRM and 0.38% to the 15-year FRM (pre-PMI) to reflect the higher rate.

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The chart includes interest and premiums for both:

• mortgage default insurance provided by the Federal Housing Administration (FHA), with charges called mortgage insurance premium (MIP); and
• private mortgage insurance (PMI), an alternative form of default insurance available from private insurers.

All premiums are provided by PMI and MIP insurers. Rates shown are sample rates for mortgage commitments in the U.S.-West, as reported by Freddie Mac. The western region includes CA, AZ, NV, OR, WA, UT, ID, MT, HI, AK and GU.

PMI rates listed on the chart are the average rates offered by California’s two largest PMI providers: MGIC, and Genworth Mortgage Insurance Co. The PMI rates are for 25% loss coverage on a conforming FRM originated at a loan-to-value ratio (LTV) of 90.01%-95% on appraised value, secured by the single family residence (SFR) occupied as the primary residence of a homebuyer with an average credit score of 700.

Mortgage choices for the homebuyer

As a general rule, mortgage lenders use a qualifying debt-to-income (DTI) ratio of 31% of the buyer’s gross income for the total monthly mortgage payment. The total monthly payment on an MIP/PMI-insured mortgage includes:

• principal and interest (PI); and
• impounds (TI) for MIP/PMI, which may encompass hazard insurance premiums, property taxes, HOA assessments and payments on Mello-Roos improvement bonds.

Thus, the inclusion of MIP/PMI in the total monthly payment diminishes buyer purchasing power by reducing the amount the buyer can borrow for failure to have at least a 20% down-payment.

The MIP offered by the FHA is made available to insure lenders against losses on a default in mortgages originated with homebuyers who obtain a low-down payment — typically 3.5%.

PMI is the only alternative to mortgage insurance issued by the FHA. PMI insurers along with the mortgages they insure require higher down payments and have more stringent credit score requirements than the FHA, but they also tend to offer lower premium rates with higher down payments.

Additionally, unlike the FHA’s MIP, PMI can be removed when the mortgage reaches 80% LTV. For FHA mortgages, the removal of the MIP depends on the original LTV:

• an LTV greater than 90% requires the MIP to remain for the life of the mortgage, or 30 years, whichever occurs first; or
• an LTV less than or equal to 90% allows the MIP be removed after 11 years.

Thus, use of PMI offers homebuyers some additional advantages over the FHA’s MIP.

In August 2014 — the last month for which data is available — 19% of Southern California mortgages were insured by the FHA, according to Dataquick. This is level with one year earlier. The remainder were either uninsured (meaning they made a down payment of over 20%) or covered by PMI.

More support for a 20% down payment

Buyers with sufficient cash on hand to submit a higher down payment can do still better: if the down payment is greater than 20%, PMI coverage is not required by lenders. However, in rare instances, when a borrower with 20% down only qualifies for FHA financing, MIP is required regardless of the down payment.

The homebuyer who has the financial ability to make a 20% down payment comes out ahead of the homebuyer whose insufficient down payment requires default insurance for the lender. Without 20% down, they are forced to pay the annual PMI fee, which is regressively based on the entire mortgage amount due. This adverse leveraging turns an MIP/PMI premium of 1% of the mortgage balance into a charge to the borrower of 6-16% on the additional funds needed to increase a down payment to 20%.

Though the additional savings paid upfront to increase the down payment and avoid the insurance premium does not earn interest in a bank account, thisopportunity cost for moving funds from savings or investments to avoid PMI insurance is well worth it. Thus, while the homebuyer may gain some interest earnings by holding onto their cash savings, the costs of holding onto the cash are far greater than the earnings a savings account will pay.

Example: different down payment amounts

For instance, consider the homebuyer who purchases a property priced at $300,000 with a 5% down payment ($15,000). To fund the remainder of the purchase price, the homebuyer opts for a 30-year FRM with mortgage insurance. With a down payment of less than 20%, they are required to provide and pay the premiums for PMI, an additional annual cost equal to 0.89% of the mortgage balance. The homebuyer has savings or access to funds for another $45,000 which may be used to bring the down payment to the 20% mark and avoid PMI.

Applying this leveraging situation to our $285,000 95% financing, the PMI premium charge payable for the first year will be roughly $2,537. This premium is entirely avoided if $45,000 is withdrawn from savings and used to increase the down payment to 20% of the price. The $45,000 is only earning 1% in a bank account — $450 annually — which will be forgone (the opportunity cost) on use of the savings to increase the down payment amount.

Thus, the additional $45,000 used to increase the down payment to avoid PMI premiums earns $2,537 the first year; a 5.64% annual rate of return, five times more than earnings on the savings withdrawn to raise the down payment to 20%.

Each year following will realize slightly lesser amounts “saved” until the mortgage principal is reduced or the home increases in value to an LTV of 78%, or five years pass and the mortgage insurance is no longer required.

Editor’s note — This yield for PMI avoidance is in addition to the implicit rent a homeowner “receives” for the use of their property, a return on the price paid for the property which is attributed pro rata to the down payment.

Homebuyers who can make a 20% down payment need to be advised of the option available to them, if not directly encouraged by their agents to make the payment. A down payment large enough to avoid mortgage insurance coverage enables buyers to reduce their monthly recurring costs of homeownership for five years. The result: a higher rate of return than would otherwise be received on the amount of the homebuyer’s savings when used to make the greater down payment and avoid the cost of MIP/PMI.