When you take out a loan to purchase a property and make a down payment of less than 20 percent of the loan amount, the lender faces a higher risk of you not being able to pay off the loan. For the lender's protection, you must either get private mortgage insurance (PMI) or pay a higher interest rate.
Features
Most U.S. lenders require a borrower with a down payment of less than 20 percent to obtain PMI, but some offer the option of paying a higher interest rate instead. If you choose to pay a higher interest rate, your lender buys the insurance and recoups the money through the higher interest income. Your lender may be able to get a lower price on the insurance and take extra profit as well.
Tax Deductions
You can claim tax deductions on the interest portion of your regular mortgage payments. Paying a higher interest rate results in a higher amount of tax deductions. With a PMI, you pay a conventional amount of interest and can only claim tax deductions on that amount. Because the PMI premium is not interest, it is not tax-deductible.
Regular Payments
If you decide to pay a higher interest rate, your monthly payments go toward the principal and the higher interest rate for the entire life of the mortgage. If you decide to get PMI, your monthly payments consist of principal, conventional interest and insurance premium. However, you only need to pay the insurance premium for a certain period of time. When your outstanding loan balance is 80 percent of the property value or less, you may be able to request to cancel the insurance.
Considerations
If you plan to remain at the property for a short period , you may want to choose to pay a higher interest rate, because you pay more interest in the first few years of a mortgage and can get more tax deductions in that period as a result. This is particularly helpful if you fall into a high tax bracket. If you expect to stay in the home for a long time or if you expect the property to increase in value quickly, you may benefit from selecting PMI, because you may be able to cancel the insurance early.
References
- "The Mortgage Professor"; Mortgage Insurance Versus Higher Rate; Jack M. Guttentag; 2007
- U.S. Department of Housing and Urban Development. "Federal Housing Administration." Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "What Is Private Mortgage Insurance?" Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "How Do Mortgage Lenders Calculate Monthly Payments?" Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "How Does Paying Down a Mortgage Work?" Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "Seven Factors That Determine Your Mortgage Interest Rate." Accessed Mar. 9, 2020.
- Rocket Mortgage. "Property Taxes: What They Are and How They’re Calculated." Accessed Mar. 9, 2020.
- Travelers. "What's the Difference Between Homeowners Insurance and Mortgage Insurance?" Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "What Is a Prepayment Penalty?" Accessed Mar. 9, 2020.
- Internal Revenue Service (IRS). "Publication 936 (2019), Home Mortgage Interest Deduction." Accessed Mar. 9, 2020.
- Consumer Financial Protection Bureau (CFPB). "TILA-RESPA Integrated Disclosures." Accessed Mar. 9, 2020.
Writer Bio
Edriaan Koening began writing professionally in 2005, while studying toward her Bachelor of Arts in media and communications at the University of Melbourne. She has since written for several magazines and websites. Koening also holds a Master of Commerce in funds management and accounting from the University of New South Wales.