I’ve never been shy about on my love for spreadsheets. And during our hunt for our first home, Ben has started to jump on the Excel bandwagon. My latest spreadsheet creation helped us parse out the options our lender gave us for financing our home purchase.
Our situation is a little more complex because we aren’t putting 20% down. And when you don’t put down 20%, you have to pay Private Mortgage Insurance (PMI). PMI protects the lender in case the borrowers defaults on their payments.
Our lender gave us the option of paying PMI out of pocket or having them pay it. If we let the lender pay it, it makes its money back by charging us a higher interest rate on our loan. The interest rate options from our lender shook out like this:
- 4.5% when we paid PMI, which resulted in the second highest monthly payment
- 4.875% when the lender paid the PMI, the lowest monthly payment
- 4.625% when we paid PMI, and we got a closing credit of $2919, the highest monthly payment
- 5% when the lender paid the PMI, and we got a closing credit of $2085, the second lowest payment
Which option would you choose?
We chose the highest interest rate: 5% rate with the closing cost credit. And the reason may surprise you.
My first task in trying to figure out which option to choose involved how much each option costs us over the life of the loan. If we were keeping the loan for the entire 30-year term, obviously the lowest interest rate wins out.
Compared to the 4.5% interest rate with PMI coming out of our pocket, we would pay $15,450 more under the lender paid PMI, $11,376 more under the buyer paid PMI with closing credit, and $26,851 in additional interest under the option we chose, lender paid PMI with closing credit.
The difference in total cost comes from the fact that PMI eventually goes away when you obtain 78% equity in the property. So the higher payments become the lowest when PMI goes away. (The tipping point was eight years and two months.)
However, the probability of Ben and me keeping the loan for the entire period seems pretty slim. So I shortened the life on the loan to a 10-year time span to see how each option faired then. The 4.875% lender paid PMI option wins here; we would pay $7,109.70 less in total than we would under the 4.5% rate, with buyer paid PMI. The 4.875% lender paid PMI with closing credit would have us paying $3, 309 less than the 4.5% (still a significant savings). The 4.625% rate, with buyer paid PMI with closing credit has us pay $3,917 more interest.
So if Ben and I get rid of the loan without riding out the entire term – which will likely happen – my thought was we were much better off choosing the lender paid PMI option.
The last question was which lender paid PMI to choose – the regular or with the closing credit. That issue involves the time value of money. You may remember that money is worth more to you now than in the future because you can invest it. The smaller monthly payment due to the lender paying the PMI allows us to keep more money in our pocket for the first 98 months of the loan. In addition, we keep more money in our pocket by getting credit for the closing costs. So the question becomes can we make up the difference in the amount we are paying for total interest. I believe we can.
The after tax interest rate will be 3.45%. So I would have to earn more than that with the money I save to offset the costs. Historically, I could do that by investing the money in my 401k or high-grade corporate bonds.
So since I believe we can make more holding on to our money and investing it, we chose to ride out the higher interest rate. And should we come up on an opportunity to get rid of the loan or refinance, we will be that much better off, despite the higher interest rate.
In the end, knowing the time value of money and making sure not to squander the savings, can sometimes make paying higher interest on a loan worth it.