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.
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.
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.
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.
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.