October 30, 2013 | Posted in:Mortgage
For my first published Case Study, we’re going to look at Downtown Derbygirl and her mortgage situation. She spends her free time competing in Roller Derby matches, and worrying about her financial situation.
She’s kind of in a bad place — at least she thought she was! — and she requested a little bit of guidance to put her back on track.
She bought a house at a young age back in 2007 with $0 cash down at closing. She ended up with a higher than average interest rate, and an obligation to pay Private Mortgage Insurance until her loan’s principle balance was under 80% of the original balance.
What does this mean for Derbygirl? An extra $127/month tacked onto her mortgage payment for the next 7 years, which is an additional 19% charge to her Principle and Interest payment.
So, how does she get rid of this silly insurance charge? She could continue making standard payments, wait it out and end up paying more than an extra $10,000 to the bank over the next 7 years. OR, she could reduce the principle of her loan as quickly as possible to become PMI-free sooner rather than later.
Let’s take a look at Downtown Derbygirl’s cash flow situation. Hopefully we can find some “extra” money for her to pump into her mortgage.
- $40k pre-tax annually
- 10% pre-tax 401k contribution (company matches up to 6%)
- $27k after-tax ($2,200/month)
- $500 rent/utilities from boyfriend
Total monthly takehome income: $2,700
- $960 Mortgage
- $250 Groceries
- $200 Utilities (varies a lot, used to have roommates, still adjusting)
- $80 Gasoline
- $37 Car/Motorcycle Insurance
- $36 Internet
- $35 Cell phone
- $30 Pet food/care
- $8 Neflix
- $100 Eating Out (down from $150, but still needs work)
- $300 Shopping (Walmart trips, bike stuff, household, fitness equip, clothes, gun/ammo)
- $200 Miscellaneous (furniture, travel/entertainment, etc)
Total monthly expenses: $2,236
And now a brief history of her mortgage situation:
- $136,000 @ 7.25% + PMI (August 2007, Original Purchase)
- $131,000 @ 4.5% + PMI (August 2011, Streamline Refinance)
- $125,500 (Current Loan Balance)
- $108,800 (80% of Original Purchase. This is where PMI payments end.)
The goal is to get Derbygirl from $125,500 to $108,800 as quickly as possible, so she can rest easy knowing that her finances are no longer under attack.
Not too long ago, she got in her own head. She noticed that her home’s value was only $81,300 according to Zillow.* This led her to believing that, “Since the value of my house is only $81,300, I’d have to get the principle down to $65k to shut PMI payments off.” Unfortunately, for a while she was considering walking away from the mortgage altogether.
The good thing is that the value on Zillow doesn’t matter whatsoever. After knowing this we can clear things up for her. All hope is not lost!
PMI, is a protective insurance measure that banks add to a mortgage payment when a buyer has less than 20% to put down at the time of closing. It provides them with a safety net for “riskier” borrowers. By law, PMI will automatically go away once the loan balance is less than 78% of the original loan value. You can request for them to remove PMI from your payments once your loan value is at 80% of the original loan value (being proactive can save you money!).
She is very economical, and spends modestly in every category from her gas consumption all the way down to her lack of cable TV. BUT, she has 3 line items on her budget that should be reduced down to one category: Eating Out, Shopping, and Miscellaneous (“fun money”). She also does not account for $474 of her spending, which is due to rent money that she collects from her boyfriend in cash.
Combined, these items total $1,064, or 39% of her monthly budget. To enable her to pay down her mortgage, she’s going to need to cut her spending in this category down to about $330 which is a modest 15% of her after tax income. Doing this will free up about $734 every month to jam into the loan. In addition, she needs to collect rent from her boyfriend in check form so she can be more accountable with her spending.
To add a little more padding into her monthly budget, Derbygirl can opt to reduce her 401k contribution from 10% down to the company match of 6%. Since she is in the 25% tax bracket, this reduction would add roughly $100 to her taxable income. This leaves her with a total of $834 in “extra” money that needs a home.
Here is the new plan for Derbygirl:
- $834/month ($734 from budget reductions and $100 from 401k reduction)
- $700 Monthly “extra” payment on mortgage (New mortgage payment: $1,660)
- $134 Liquid Savings (Current savings: $500)
Adding an additional $700 to her mortgage payment, she will be able to pass the 80% loan-to-value threshold, key in dropping PMI payments, by May 2015.
That’s only 19 more payments (compared to the 65 payments it would have taken naturally)! By May 2015, her savings account balance will be $3,046, which included $2,546 in contributions between now and then.
Over the span of the next 19 months, Derbygirl is going to witness two more tax seasons. While I’m not going to forecast expected returns, it would be silly to think that she wouldn’t get a decent sized return both times. With her first tax return, she can give this new plan an extra boost, or continue to build a padded savings account. By the time the second tax return is deposited into her bank account, she will be PMI free.
PMI freedom will have her standing at a crossroads: either to invest or to pay off the mortgage as soon as possible. It would take her until April 2023 to pay off the mortgage if she continues at the same rate of attack. If she were to invest the “extra” $700 every month instead she will have amassed around $84k worth of assets (5% compounded inflation-adjusted).
Another thing to think about is the fact that she will no longer be obligated to spend the extra $127 every month on her PMI payment. This will increase her monthly positive cash flow. With that, my advice would be to invest and return to minimal mortgage payments.
To further reduce stress, she could try to figure out a way to increase her hourly pay, or she could develop skills that she could turn into a side hustle for extra cash. When you’re trying to get out of a bad situation, every little bit helps.
We can turn this conversation to investing when Downtown Derbygirl is PMI free. Good luck!
Zillow is a garbage dump of outdated data and inaccurate information. It should not be viewed as factual information.*