The True Cost of PMI: Why you should pay down your low-interest mortgage

Why Paying Down a Low-Interest Mortgage to Eliminate PMI Can Be Worth It

Finance experts often warn against paying down a low-interest mortgage early. The reasoning behind this advice is simple: you can often get a better return by investing your money than by using it to pay down a low-interest loan.

Why Investing Often Beats Paying Down a Mortgage

For example, the return on paying down a mortgage with a 3% interest rate is 3%. If savings accounts are paying 4% interest, you’ll get a 1% better return by keeping your money in a savings account than by making extra payments on your mortgage.

While 1% may not seem significant, the numbers become far more compelling when you consider other investments with higher expected returns. The S&P 500 index, for instance, has delivered an average annual return of around 10.26% since its 1957 inception through the end of 2023.^[1]

When you compare a 3% mortgage interest rate to the market’s 10% average return, it seems obvious: invest your money rather than paying down your mortgage.

But that’s not the whole story.

Private Mortgage Insurance (PMI) Changes the Equation

Lenders typically require private mortgage insurance (PMI) on loans where the borrower’s down payment is less than 20% of the home’s value. PMI protects the lender if the borrower defaults, but it provides no direct benefit to the borrower—yet the borrower pays for it.

In my case, PMI was costing me $115.63 per month, which adds up to nearly $1,400 a year. That’s as much as my electricity bill, which includes driving an electric car! Paying this to protect my lender just didn’t sit right with me, so I started looking into ways to remove it.

Two Ways to Remove PMI

I looked at my mortgage docs to see how I can remove PMI, and it described two ways:

1. Automatic Removal: PMI is automatically removed once the principal balance of your mortgage falls below 80% of the home’s original value.

2. Apply for Removal: You can apply to have PMI removed if you get an appraisal showing that your loan balance is less than 80% of your home’s current value.

I ruled out option #2 because appraisals are expensive. Spending hundreds of dollars for an appraisal, on top of paying for PMI, felt like throwing good money after bad.

That left me with option #1: paying down the mortgage principal to reach the 80% loan-to-value (LTV) threshold. This approach required a larger upfront cash outlay (a much, much larger outlay), but every dollar would go toward reducing my loan balance, lowering the amount of interest I’d pay over the life of the loan.

Crunching the Numbers

After reviewing my mortgage documents, I calculated that I needed to pay down $32,181.73 to get my loan-to-value ratio below 80%. Without making extra payments, I’d reach this threshold in about 32 months. But waiting that long meant continuing to pay PMI, so I decided to evaluate the cost of eliminating PMI sooner.

Using Excel, I analyzed the numbers. The nominal interest rate on my mortgage is 2.75%. If I treated the $32,181.73 as a standalone loan with a 32-month term, my monthly payment would be:

=PMT(annual_mortgage_interest_rate/12, months_until_PMI_goes_away, principal_required_to_remove_PMI) - monthly_PMI_payment

For me, the calculation looked like this:

=PMT(0.0275/12, 32, 32181.73) - 115.63

Result: -$1,159.79

Next, I calculated the effective return of eliminating PMI using this formula:

=RATE(months_until_PMI_goes_away, monthly_payment_from_previous_calculation, principal_required_to_remove_PMI)

For me:

=RATE(32, -1159.79, 32181.73)*12

Result: 10.66%

This means that by paying down my mortgage to remove PMI, I’d get a guaranteed return of 10.66% on the money I used to make the extra payments.

Why Paying Down PMI Was Worth It

Unlike investing in the stock market, which carries risk and no guarantees, the return from eliminating PMI is certain. Every dollar I used to pay down my mortgage effectively saved me from paying PMI fees and reduced my future interest payments. At a guaranteed 10.66% return, this strategy far exceeded the expected return of most investments, even in a strong market.

The Takeaway

While paying down a low-interest mortgage might not always make sense, the equation changes when you factor in the cost of private mortgage insurance. In my case, eliminating PMI offered a guaranteed 10.66% return—a compelling reason to prioritize paying down my mortgage over other investments.

If you’re paying PMI, consider running the numbers for your situation. You might find that eliminating PMI is one of the best (i.e., highest return for the least amount of risk) investments you can make.