May 21, 2022

Here’s One Way to Avoid Private Mortgage Insurance – But There Are Risks

If you’re making a small down payment on your home, a piggyback loan might help you avoid some extra costs on your mortgage. However, these types of loans aren’t without their own costs and drawbacks. Here’s what you need to know.

What Is a Piggyback Loan?

Homebuyers use piggyback loans to avoid paying private mortgage insurance, which typically kicks in if your down payment is below 20% of the home’s selling price. PMI acts as an insurance policy to protect the lender if you fall behind on payments or default altogether.

A piggyback mortgage arrangement typically offers a primary mortgage for 80% of the home’s value, plus a home equity product to make up the difference between your down payment and the remaining 20%.

The piggyback loan typically comes with a higher interest rate than the first mortgage, and the rate can be variable, which means it can increase over time.

Piggyback loans became popular during the housing boom in the early to mid-2000s. In 2006, for instance, roughly 30% of homebuyers in New York City used one, according to a 2007 report from the NYU Furman Center.

The loan combination made it possible for aspiring homeowners to buy the homes they wanted and avoid PMI without putting down 20% or more in cash. But it also left their homes more vulnerable to default.

When the national housing bubble burst in the late 2000s, homeowners with less equity in their homes were more likely to default than others who had significant equity.

Piggyback mortgages still exist but are rare. “There was a decrease in popularity but also a substantial tightening up of the guidelines by the lenders that offer those piggyback second mortgages,” says Jeff Brown, a branch leader and mortgage originator for Axia Home Loans.

And they’re not seeing much of a comeback, even with the recent spike in home prices. According to Ralph DiBugnara, CEO of Home Qualified, a digital real estate resource, “the need has been reduced with the expansion of mortgage products that require less than a 20% down payment and do not require PMI.”

Types of Piggyback Loans

There are a few different ways you can structure a piggyback mortgage. Here’s how the different options break down based on your primary mortgage loan, piggyback loan and down payment.

  • 80/10/10 loan. This option is worth considering on a conventional loan and involves a primary mortgage covering 80% of the sales price, a piggyback loan financing 10% and a down payment covering the remaining 10%.
  • 80/15/5 loan. This option works similarly to the 80-10-10 loan, but instead of putting down 10% and borrowing the remaining 10% with a piggyback loan, you’re only putting down 5% and financing the remaining 15% with the second home loan.
  • 75/15/10 loan. This option, which involves a 15% piggyback loan and a 10% down payment, may be used when buying a condo. This is primarily because mortgage rates for condos tend to be higher if the loan-to-value ratio is higher than 75%.
  • 80/20 loan. This arrangement, which was popular during the years leading up to the 2007 housing crisis, didn’t require a down payment at all. You’d simply take out a primary mortgage to finance 80% of the sales price and 20% with a secondary loan to cover the rest. This piggyback arrangement isn’t common anymore, though.

Pros and Cons of Piggyback Loans

If you’re considering a piggyback mortgage, it’s important to understand both the benefits and the drawbacks.

Pros of Piggyback Loans

It could save you money. PMI can cost between 0.3% and 1.5% of your loan amount annually. So if your mortgage is for $250,000, you could be on the hook for $750 to $3,750 in PMI premiums each year. That translates to a monthly payment of $62.50 to $312.50 on top of your principal and interest payment to your lender, plus property taxes.

Depending on how much the second mortgage costs in monthly payments, you could end up paying less than you would with PMI. But it easily could go either way, says DiBugnara. “Some second mortgages used for piggyback loans will carry a much higher interest rate,” he adds. “In that case, it’s very likely that the payment will be higher than a PMI payment.” Make sure you do the math to find out which option is better in your situation.

You can deduct interest from both loans. The IRS allows you to deduct interest paid on up to $750,000 in qualified mortgage debt ($375,000 if you’re married but filing your tax returns separately). That includes home equity loans and HELOCs used to buy, build or substantially improve the home used as collateral.

Adding these savings into your calculation of whether a piggyback loan can save you money can make things more complicated. Also, it can be tough to know exactly how much you could save – or even if it makes sense to itemize your deductions and claim the mortgage interest deduction at all – unless you speak with a tax professional.

You can keep a HELOC for other purposes. A home equity loan is an installment loan, which means you get the full loan amount as a lump sum and pay it back in equal installments. With a HELOC, however, you’ll get a revolving form of credit during the draw period, which you can pay back and borrow again over time to pay for home improvements and other expenses.

Cons of Piggyback Loans

Closing costs could reduce value. In addition to paying closing costs on your first mortgage, you may need to pay closing costs on your home equity loan or HELOC. However, some lenders offer home equity products with low or no closing costs. You’ll want to find out what the lender charges so you can include it in your calculations.

Even if closing costs are low, the math may still not work out in your favor, and paying PMI could end up being cheaper than taking on a second home loan.

It could make refinancing tough. If you get your piggyback loan from a different lender from the one that provides your first mortgage, which is typical, refinancing your home to get cash out or score a lower interest rate could be more difficult later.

This is because both lenders would need to agree to the refinance unless you’re taking out a big enough refinance loan to pay off the second mortgage. Convincing both lenders can be tough, especially if the value of your home has declined since you bought it.

The cost could go up over time. If the second loan you’re taking out is a HELOC with a variable interest rate, don’t base your calculations solely on the current cost of each option.

A variable interest rate can fluctuate with the market index interest rate. There’s no way to know exactly how much more a variable interest rate can cost you, because it’s impossible to predict the movements of market interest rates. If you’re on a tight budget and can’t handle having your mortgage payment increase over time, a variable-rate piggyback loan may not be a good choice.

How Do You Qualify for Piggyback Loans?

Qualifying for a piggyback loan can be difficult because second mortgage lenders may have different eligibility requirements. While the specifics can vary from lender to lender, here’s what you’ll typically need to get approved for both loans:

  • Credit score. You’ll typically need a FICO score of 620 or higher for the primary mortgage, but the minimum for the secondary mortgage can be 680 or higher.
  • Debt-to-income ratio. Mortgage lenders like to see a debt-to-income ratio of 43% or lower, and that includes both the primary and secondary home loans.

Note that a smaller down payment will also typically result in higher interest rates.

Piggyback Loan Alternatives

Look for loans with no PMI. Some lenders offer conventional loans with no PMI even if you don’t have a 20% down payment. Depending on the lender, this can be restricted to a first-time homebuyer or low-income program, or you may need to agree to a slightly higher interest rate.

As with a piggyback loan, run the numbers to make sure you’re not paying more in the long term with a higher rate than you would with PMI.

Pay down your balance quickly. Conventional mortgage lenders will usually add PMI to your loan if your loan-to-value ratio is higher than 80%, but eventually your loan balance should fall under that threshold. Lenders are required by law to automatically remove the PMI once your LTV reaches 78% based on the original loan and home value.

If you’re expecting a significant windfall or have the cash flow required to make extra payments, it could help reduce your loan balance more quickly and get you to the point where you no longer need the insurance.

As you’re working on paying down your balance, if you think your home’s value has increased and you’re at or below 80%, you can get an appraisal done on the house. If you’re right, you can request that the lender remove the PMI manually.

Wait until you’ve saved enough. While there are ways to buy a home now and avoid PMI, you might be better off waiting until you have enough cash on hand for a 20% down payment.

Saving the 20% you need to avoid PMI can take years. But if you think you can save enough cash quickly, it may be worth it to wait.

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