You found a home you love, but the problem is you do not have 20% to put down on the home. Before you walk away from what you thought was your dream home, consider your two options. You can pay PMI or take out a HELOC. Before you decide which option is right for you, learn about the differences here.
What is PMI?
PMI or Private Mortgage Insurance is an insurance policy that protects the lender. However, you pay the premiums. Lenders require this insurance when you put less than 20% down on the home. The insurance covers them if you were to default on the loan. The premiums vary based on your loan amount and credit history. You pay annual premiums, however, the lender divvies them up over the course of the year. You pay 1/12th of the amount each month on your mortgage payment.
What is a HELOC?
A HELOC or Home Equity Line of Credit is a second mortgage. Normally, borrowers take out this type of loan when they need cash out of the equity of their home. As a homebuyer, you can use the money to put towards the purchase of your home. HELOCs work like a credit card – you use the money and pay interest on it. You can keep reusing the money as long as you pay the balance down or off. This goes on for a period of 10 years in most cases. After the 10 years, you can no longer draw the funds. At this point, you begin making interest and principal payments to pay the loan off in full.
The Benefits of PMI
Just like anything else in life, there are benefits to paying PMI. That might seem like a difficult thing to accept. What could be good about paying insurance premiums that you will never see any benefit from? Here are some of the most common benefits:
- You can usually borrow more money when you pay PMI. Most HELOC programs max the loan-to-value ratio at 85%. PMI, however, often allows borrowers with good credit to borrow as much as 95% of the value of the home.
- PMI goes away eventually. You don’t have to pay the premiums forever. Once you owe less than 80% of the value of the home, you can request for cancellation of the insurance. If you don’t request it, the lender must cancel your premiums when you hit 78% LTV – it’s the law.
The Benefits of a HELOC
The HELOC does have a few more benefits than Private Mortgage Insurance, but that does not always make it the right choice. Here are the benefits of the HELOC:
- You only have to make interest payments. This allows you to borrow more money and not increase your payments so much that you cannot afford them.
- The payments you do make go directly to the loan. If you pay more than the minimum interest payment, it begins to pay your loan down.
- You might be able to write off the interest you pay on your income taxes.
- You don’t need approval to pay off a HELOC; you can do so at any time.
Deciding Between the Two
If you take a quick look at both options, you can see how they may be difficult to choose between. Private Mortgage Insurance does not require you to hold another mortgage. You don’t have another lien on your house and yet you can borrow up to 95% of the value of the home. However, a HELOC offers greater flexibility and gives you the feeling of investing in your home rather than throwing money out the window.
You should base your final decision on the difference in the payments. For example, if your PMI payment will be rather high, it might not make financial sense to pay for it. If you know you can secure a HELOC with a payment you can afford, you have the benefit of having a line of credit at your disposal. This can help serve as an emergency fund in the future, if need be. In addition, you have the benefit of writing off the interest you pay on this loan. On the other hand, if you are not comfortable with payments that vary each month or with having a second mortgage, the PMI might be the better option.
Either way, you have to qualify for the program. Private Mortgage Insurance adds to the payment you must make each month. The lender includes this in your debt ratio. You must be able to fit it into your monthly obligations and meet the required ratios. You obviously also have to qualify for the HELOC loan, which might be a little more difficult. The payment will be higher than PMI in most cases, even if it is just interest only. Understanding where you stand and how it affects you will help you make the right decision.
There is no right and wrong answer regarding Private Mortgage Insurance and a HELOC. It is up to you to decide. Take a close look at your financial situation now and in the future. Obviously, you cannot predict the future, but you have an idea of what you want. For example, if you are two-income family now, but you plan to stop working to raise a family, this should play a role in your decision. You might want to opt for the lower payment even if you know you could afford now. This way, in the future, you will not have to sacrifice as much.
The best thing to do is get a few quotes from different lenders and talk the situation over with them. In addition, it is not a bad idea to talk to your tax advisor. He may have some strong feelings regarding a HELOC or PMI and how they could affect your financial situation. Using the advice you receive, you can then make the right decision for yourself.