Home purchasers who were obliged to take out private
mortgage insurance (PMI) because their down payment was less
than 20% of the price have the right to cancel it, ridding
themselves of the monthly premium. Borrowers should take
advantage of the opportunity if they can but they must meet
the cancellation rules.

##
__Cancellation Rules__

Under Federal law, lenders are required to cancel private
mortgage insurance on most home mortgage loans made after
July 29, 1999. Cancellation will occur automatically when
amortization has reduced the loan balance to 78% of the
value of the property at the time the loan was made. The
borrower cannot accelerate this process with extra payments.

Under another provision of this law, lenders must terminate
insurance at the borrower’s request when the loan balance
hits 80% of the original value. Borrowers can accelerate the
process of getting to 80% by making extra payments.

Warning: A lender need not accept a request for cancellation
if the borrower has taken out a second mortgage or had an
excessive number of delinquencies in the prior two years, or
if the property has declined in value.

If Fannie Mae or Freddie Mac own the mortgage, the
cancellation rules apply to the current appraised value of
the property rather than the value at the time the loan was
made. Borrowers can request cancellation after two years if
the loan balance is no more than 75% of current appraised
value, and after 5 years if it is no more than 80%.
The ratios are lower if there is a second mortgage, if the
property is held for investment rather than occupancy, if
the property is other than single-family, or if the borrower
has had recent delinquencies.

##
__Paying Off PMI as an Investment__

Homeowners should view paying off PMI as a potential
investment that can yield a high return. Until now, figuring
out how large that return was exceeded the capacities of
almost all borrowers, but no longer. My colleague Allan
Redstone has developed a PMI payoff spreadsheet, which shows
the investment required to eliminate PMI, and the rate of
return on that investment, for each of three rules: 80% of
original value, 75% of current value after 2 years, and 80%
of current value after 5 years The spreadsheet is on my web
site for anyone to use.

A unique feature of PMI payoff as an investment is that the
amount of the investment is a specific dollar amount. Hence,
the borrower’s decision must consider not only the rate of
return but also whether or not they have the exact amount
required.

Here is an example. Three years ago, the borrower purchased
a house for $200,000 with a 30-year fixed-rate mortgage of
$190,000 at 4%, and a monthly mortgage insurance premium of
$65. She expects to be in the house another 4 years. The
house is now worth $225,000, requiring an investment of
$11,098 to bring the loan balance down to $168,750, which is
75% of $225,000. The return on investment in dollars is the
$65 a month insurance premium for 68 months, plus the
$14,280 difference in the loan balance in month 84 when the
owner expects to sell the house. The rate of return is 8.96%

Note that the $65 monthly saving in mortgage insurance
extends for only 68 months because in month 69, the ratio of
loan balance to original property value falls below 78%,
which under the law requires the lender to cancel the
policy.

##
__Borrowers Paying Higher Premiums Earn
a Higher Return__

The example described above applied to a relatively low-risk
transaction that carried a very modest mortgage insurance
premium. The transaction assumed a single-family home, a
purchase for occupancy, and a credit score of 800.

Borrowers with poor credit pay more when they borrow, but
there is a reverse side to that coin. When they invest in
reducing their obligations, the rate of return is
correspondingly high. If the purchaser in my example
intended to rent the house rather than occupy it, and if her
credit score was 620 rather than 800, her insurance premium
would be almost 6 times larger. In that event, the rate of
return on the investment required to eliminate the insurance
would be 39.26%.

##
__How the Passage of Time Affects the
Investment__

Intuitively, it would appear that the sooner you pay down
the balance and rid yourself of the PMI premium, the better
off you will be, but this may or may not be the case. It
depends on the circumstances and preferences of the
borrower.

Consider the example given earlier where after three years
the borrower earns 8.55% on an investment of $11,098. If the
same borrower decided to make the investment after 4 years
instead of 3, her dollar savings would be smaller because
both the number of PMI premium payments and the balance
reduction in the payoff month would be smaller. On the other
hand, the required investment would be $7326 instead of
$11,098, which might make it affordable, and the rate of
return on investment would be 10.52% as compared to 8.55%.

In general, the longer the borrower waits to pay down the
balance to the point where the PMI is eliminated, the
smaller is the savings in dollars and in the investment
required, but the higher is the rate of return on
investment. The power of the spreadsheet is that it allows
each individual borrower to adopt the payoff strategy that
best fits her needs and capacities.

##
__Comparison with Other Investments__

In comparison to other investments, an investment in PMI payoff ranks very high on default risk, because there is none, and on expected return. The drawback has been the complexity of the process, which has made it difficult to determine exactly what the rate of return is. Eliminating this uncertainty is the reason we developed the spreadsheet.

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