The interest rate on your mortgage is definitely an important consideration but it’s not everything. There are some cases in where you may actually want to take a higher rate. I know that doesn’t sound right and you may be wondering if you read that correctly. It makes sense to try to get the best possible mortgage rate available but you also need to consider all factors including the payment. OK, so up until this point you probably have thought of the interest rate and payment as being synonymous. The interest rate on your mortgage definitely does have an effect on your payment but there is another very important factor as well. Any time you borrow more than 80% of the sales price of the home that you are purchasing you will be required to pay PMI. The absolute lowest rate usually comes with a conventional mortgage. Without a 20% down payment or more you will also be stuck with .92% PMI on top of your payment.
PMI stands for Private Mortgage Insurance. It is a monthly premium that the bank charged to hedge their risk. There is a consensus that when a lender extends more than 80% of the sales price to a borrower in the form of credit to purchase a home that there is a higher risk of default. Generally speaking, when you have less invested in the home you may be more willing to walk away from your debt obligation when something goes wrong than if you were more fully invested. Not everyone is the same and you may have every intention of sticking it out but that is the way that the bank sees it. To hedge against this loss they charge you PMI. The thing about PMI is that while it is technically not interest it is paid on top of your mortgage rate and essentially creates a higher effective rate. As an example if you receive a 4% flat interest rate you will actually be paying an equivalent to 4.92% after factoring in PMI.
Tax Benefits of a Higher Mortgage Rate
Your mortgage interest is tax deductible each year while PMI is not. In the above example with a mortgage rate of 4% that annually accrued 4% is deductible but the .92% on top of it is not. Keeping that in mind you may make out better even if you are paying the exact same thing. If you were to receive a 4.92% mortgage rate with no PMI you would have a greater tax advantage and in the long run spend less overall after factoring your return. So what are the alternatives if you are unable to bring a 20% down payment? Here are a few:
USDA Guaranteed Rural Housing Home Loan
This one is not going to work for everyone. In order to make this one work there are some underlying requirements. First, you must earn the average median income or less for your area. The next requirement is that the home be located in a non-urban area. For more information on property eligibility please visit the USDA Property Eligibility Website. USDA Home loans do require PMI as well but the rate is .5%. In reference to the above example, if you were to obtain a 4.25% with a USDA Home Loan and pay .5% PMI you effective rate would now be a 4.75% with 4.25% of that tax deductible annually. You would technically have a higher interest rate than with a conventional mortgage but your payment would be lower and you would have a greater tax deduction.
VA Home Loan
Rates vary with every program and VA home loan rates are not always higher than conventional. Sometimes the mortgage rate with a VA home loan is equal to or less than that of a conventional mortgage. However, even if the pricing is much higher at the time of your lock you will still benefit greatly because there is no PMI, your payment will be lower as a result, and every bit of your interest is tax deductible. In order to qualify for a VA home loan you must be an eligible veteran and meet the minimum lending guidelines and credit overlays laid out by the lender.
Make a 20% Down Payment
Of course this is your best option if you are in the best financial position that you could be in. Bringing a 20% down payment will ensure that you get the lowest rate with zero PMI on a conventional mortgage. Not everyone is in position to be able to make this significant a down payment but if you are this is definitely the route that you should go. You will get the best rate at the lowest payment and have the greatest tax advantage.
People looking to purchase a home are often times very rate conscious even when they lack a down payment. This is even more difficult if the borrower does not have the absolute best credit standing. In our view is is better to take a 4.25% mortgage rate with a PMI of .5%, when it is available, than to take a 4% mortgage rate with .92% PMI. These options will not exist in every situation or in every market but when the option is there the best option is to take the lower payment with the greater tax deduction regardless of the mortgage rate.
(Originally Posted on my original Blog and re-posted here: The Mortgage Daily Press)