Break Even Point

Big Red asked what I meant by "break-even" on my last post so here is my explanation. He may have only wanted a brief description ... but my intention was to write up a detail description of the math I did (including charts and spreadsheets) ... but I am way tired for some reason so here is something in-between (skip to the example if you just want numbers) ....

(Any and all info may be wrong. This is what I believe to be true and what I based my decisions on. If anyone finds a mistake please let me know, but don't be surprised. It has happened once before. Maybe twice)

Lending money is risky. Lending large amounts of money is riskier. Lending large amounts of money against something that might lose value or burn down is even riskier. Therefore, mortgage lenders take out insurance against the situation where you can't pay them, and they can't sell the property to recoup their investment. Thus, Private Mortgage Insurance.

To make things even better, you the borrower get the opportunity (must) pay the PMI for your lender. Basically your paying for the insurance of you defaulting ..... if you have less than 20% equity in your home (someone, somewhere statistically decided that if you have >20% equity in the home then the chance of you defaulting AND them not being able to get their money back is low enough that they don't need insurance).

What is home equity? Basically the difference between the home's value and the loan against it. So, with each mortgage payment you pay starting with your first and until you have >20% equity built up (and have had the home re-appraised and gotten the lender to agree to remove it) you must also send in your PMI payment. The PMI amount is based on some percentage of the loan amount (I can't remember the exact formula) but for us its about 7.3% of a month's payment. After you have 20%, you don't pay it any more.

A second option our lender had was a form of "financed PMI". It boiled down to: A) you don't pay PMI ever, no matter the equity and B) your interest rate is a small bit higher. How much higher? Our initial good faith estimates put it at 3/8% higher. Under this plan, you pay a higher mortgage payment for whole life of the loan ... which is less than the original mortgage payment + PMI.

Assuming the "normal" monthly mortgage bill as our "zero", the normal PMI option added around $77 to our bill each month while the "financed" option added $33. However, the $77 is only paid until you have 20% paid off, while the $33 is paid for the whole term of the loan.

So ... after many paragraphs ... the break-even point I referred to is the amount of time (number of payments) at which point both choices are essentially equivalent.

For example:

If you wanted a $200,000 home and could put 10% down ($20k) your payments would be about $1,065 / month (not including taxes, insurance, utilities or anything else). Assume you pay the minimum each month and the interest rate is 5.875% (PMI) and 6.25% (financed PMI).

If you go the PMI route, you pay an extra $77 / month that doesn't go toward the principle or interest (total payment = $1,142). Since at the beginning of a loan most of the payment is interest, it will take you aprox 89 payments or 7.4 years to get to 20% equity ... at which point you don't pay any more PMI. However, cumulatively you have now payed a total of $6,853 in PMI.

If you had chosen the financed route, your mortgage payments would be $1,108 which is $33 cheaper than the PMI option. After 89 payments you will have paid $2,979 LESS than the PMI option. IF you took $1,133 of that savings and put it toward your principle you would also have 20% equity in your home and still be $1,845 ahead. However, starting with the 90th payment your now paying $43 MORE than you would be otherwise.

Essentially, each payment going forward is taking $43 out of the $1,845 savings and after 41 payments your at the break even point. At this point, 10.8 years later, with either option you would have paid the same amount of money.

So, if you plan on living in the house <10.8>10.8 years, regular PMI is the way to go. Simple, right?

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Thats the simplest version. If you put more down, then you will get to 20% faster and the break even point moves up (15% down with the same figures means a break even point of only 6.75 years). Also, if you plan to pay anything extra each month or at all, this can moves things up dramatically (mainly b/c at first the amount of principle you are paying is small, so extra contributions really add up). If you averaged just $50 extra each month, the BEP moves up to 9 years (6.6 years averaging $150).

Also, as I typed this, I realized something else that I hadn't thought of until now .... at the break even point you will have paid the same amount either way, but will have slightly less equity in your home with the financed option ... b/c your interest rate is higher, your paying less principle each month. This will move the BEP up slightly but I don't care enough to recompute the numbers.

AND this doesn't take into account 80/20 programs which I hear are more rare now, where you take out one loan for80% and another for 20% at a higher rate but don't pay any PMI since niether is >80. We didn't look into these so I can't really explain them much more.

Basically, if just depends on how long you think you will live there. If its less, the financed option makes a ton of sense (or if you think you could refinance to a lower rate but given how low things are at the moment, thats probably unlikely). If you think it will be more (our situation) then the PMI made more sense. If your anywhere close, then the difference will be small (a few hundred dollars) so it really wouldn't matter.

You can find a slightly screwed up Google Spreadsheet (imported from excel) with some of the formulas I used, HERE. Yes I spent too much time on it and yes its not complete but it did what I needed. Plus I am a huge nerd.

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Wow, that was a TON longer than I wanted ... hopefully it answers your question and makes some sense, and isn't completely wrong.

If anyone else has any questions please feel free to ask.


Oh yeah, its my birthday :-) so I am going to go to bed now. Thank you to everyone who wished me a happy one and thank you to everyone who didn't know but now feels guilty (don't be).