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Equity Now In The News - 2019

How Piggyback Loans Work

 

U.S. News & World Report | @usnews

October 17, 2019, 8:00 PM

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 Are Piggyback Loans?

A piggyback loan is a second mortgage — usually a home equity loan or home equity line of credit, also called a HELOC — that you take out alongside a mortgage.

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%. A common piggyback loan is an 80-10-10, which includes a first mortgage for 80% of the home’s value and a home equity loan or HELOC for 10%. You’d be responsible for the 10% down payment.

There are other combinations, such as 80-15-5 or 80-5-15, where the portions covered by the piggyback loan and your down payment vary.

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.

[Read: Best Personal Loans.]

The History of Piggyback Loans

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 loans 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.

Pros of Piggyback Loans

It could save you money. PMI can cost anywhere 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 and 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. A $25,000 loan with a 30-year term at 7% will have a monthly payment of $166.

That might be lower than a $312.50 monthly payment for PMI, but remember that PMI generally can be removed when your equity reaches 20%. A piggyback loan remains even after you reach 20% equity, so you could still be making monthly payments on a piggyback home equity loan long after you would have been off the hook for PMI.

You’ll need to do some math to find out which option is better. This means you’ll need to work with your lender to find out how much the PMI would cost and what monthly payment to expect if you apply for a second mortgage.

You may only get quotes on each, which are typically contingent on a few factors considered during the application process, but an estimate may be enough to give you a good idea of the difference.

If your credit is less than stellar, the interest rate on a second mortgage could be high enough to make it more expensive. But if your credit is in great shape, the math could work in your favor.

You can deduct interest from both loans. The IRS allows you to deduct interest paid on up to $750,000 in qualified mortgage debt. 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.

“If you take a HELOC as your piggyback and you plan on paying it down but want to have it available to draw on going forward, that may make more sense than getting a first mortgage with PMI because you don’t have that added feature,” says Matt Hackett, operations manager at Equity Now, a direct mortgage lender.

If you’re thinking about taking out a loan in the coming years for home improvements or for other reasons, using a HELOC now that you can use again and again without needing to apply for a new loan — and pay closing costs all over again — could be an extra benefit. Just keep in mind the draw period is typically around 10 years, followed by a repayment period of 15 to 20 years.

[Read: Best FHA Loans.]

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 than 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.

[Read: Best Mortgage Lenders.]

Other Ways to Avoid Private Mortgage Insurance

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.

How Piggyback Loans Work originally appeared on usnews.com

 
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