How piggyback loans work | Mortgages and Advice
If you have a small down payment on your home, a piggyback loan can help you avoid some additional costs on your mortgage. However, these types of loans are not without their own costs and disadvantages. Here’s what you need to know.
What is a piggyback loan?
Homebuyers use piggyback loans to avoid paying a personal mortgage insurance policy, which typically kicks in when your down payment is less than 20% of the home’s selling price. PMI acts as an insurance policy to protect the lender if you default on payments or default altogether.
A piggyback mortgage agreement typically offers a primary mortgage equal to 80% of the home’s value and a home equity product to make up the difference between your down payment and the remaining 20%.
The piggyback loan usually has a higher interest rate than the first mortgage, and the interest rate can be variable, meaning it can increase over time.
Piggyback loans became popular during the real estate boom of the early to mid-2000s. For example, in 2006, about 30% of homebuyers in New York City used one, according to a 2007 report by the NYU Furman Center.
The loan combination allowed would-be homeowners to buy the homes they wanted and avoid PMI without putting up 20% or more in cash. But it also made their homes more vulnerable to defaults.
When the national housing bubble burst in the late 2000s, homeowners with less equity in their homes were more likely to default than those with significant equity.
Piggyback mortgages still exist but are rare. “There’s been a decline in popularity, but also a significant tightening of policy by the lenders who are offering these piggyback second mortgages,” said Jeff Brown, industry director and mortgage lender at Axia Home Loans.
And they’re not seeing a big comeback, even with the recent surge in house prices. According to Ralph DiBugnara, CEO of Home Qualified, a digital real estate resource, “Needs have been reduced with the expansion of mortgage products that require less than a 20% down payment and require no PMI.”
Types of piggyback loans
There are several ways you can structure a piggyback mortgage. Here’s how the different options break down based on your primary mortgage loan, your piggyback loan, and your down payment.
- 80/10/10 loan. This option is worth considering with a traditional loan and involves a main mortgage covering 80% of the sale price, 10% piggyback loan financing, and a down payment covering the remaining 10%.
- 80/15/5 loan. This option works similar to the 80-10-10 loan, but instead of depositing 10% and borrowing the remaining 10% with a piggyback loan, you deposit just 5% and fund the remaining 15% with the second home loan.
- 75/15/10 loan. This option, which includes a 15% piggyback loan and 10% down payment, can be used when purchasing a condo. This is mainly because condo mortgage rates tend to be higher when the loan-to-value ratio is higher than 75%.
- 80/20 loan. This scheme, popular in the years leading up to the 2007 housing crisis, required no down payment at all. You would simply take out a primary mortgage to fund 80% of the sale price and 20% with a secondary loan to cover the rest. However, this piggyback arrangement is no longer common.
Pros and cons of piggyback loans
When considering a piggyback mortgage, it’s important to understand both the pros and cons.
Advantages of piggyback loans
It could save you money. PMI can cost anywhere from 0.3% to 1.5% of your loan amount annually. So if your mortgage is $250,000, you could get anywhere from $750 to $3,750 in PMI awards each year. That equates to a monthly payment of $62.50 to $312.50 in addition to your principal and interest payment to your lender, plus property taxes.
Depending on how much the second mortgage costs in monthly installments, you could end up paying less than PMI. But it could easily go either way, DiBugnara says. “Some second mortgages used for piggyback loans will have a much higher interest rate,” he adds. “In this case, it is very likely that the payment is higher than a PMI payment.” Be sure to do the math to find out which option is better in your situation.
You can deduct the interest from both loans. The IRS allows you to deduct interest paid on up to $750,000 of qualifying mortgage debt ($375,000 if you’re married but file your tax returns separately). This includes home equity loans and HELOCs used to purchase, build, or substantially improve the home used as collateral.
Factoring these savings into your calculation of whether you can save money with a piggyback loan can complicate matters. Also, it can be difficult to know exactly how much you could save — or whether it even makes sense to break down your deductions and claim the mortgage interest deduction at all — unless you speak to a tax expert.
You can keep a HELOC for other purposes. A construction loan is an installment loan, ie you receive the entire loan amount in one sum and pay it back in equal installments. However, with a HELOC, you receive a revolving form of credit during the draw period that you can repay and borrow again over time to pay for renovations and other expenses.
Disadvantages of piggyback loans
Closing costs could reduce the value. In addition to the closing costs of your first mortgage, you may have to pay closing costs for your home loan or HELOC. However, some lenders offer home equity products with low or no closing costs. You should find out what the lender charges so you can factor it into your calculations.
Even if closing costs are low, the bill may not work out in your favor, and paying PMI could end up being cheaper than taking out a second home loan.
That could make refinancing more difficult. If you get your piggyback loan from a different lender than the one providing your first mortgage, which is typical, it could be more difficult later to refinance your home to get a payout or a lower interest rate.
This is because unless you take out a large enough refinance loan to pay off the second mortgage, both lenders would have to agree to the refinance. It can be difficult to convince both lenders, especially if your home has gone down in value since you bought it.
The costs could increase over time. If the second loan you take out is an adjustable-rate HELOC, don’t just base your calculations on the current cost of each option.
A floating interest rate can fluctuate with the market index interest rate. There is no way to know exactly how much more a variable interest rate may cost you as it is impossible to predict movements in market interest rates. If you’re on a tight budget and can’t handle an increase in your mortgage payment over time, an adjustable-rate piggyback loan might 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 specifics may vary from lender to lender, to be approved for both loans, you typically need the following:
- Credit-worthiness. You 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 less, and that includes both primary and secondary home loans.
Note that a lower down payment usually translates into higher interest rates.
Piggyback loan alternatives
Look for loans without a PMI. Some lenders offer traditional loans without a PMI even if you don’t have a 20% down payment. Depending on the lender, this may be limited to a first-time buyer or low-income program, or you may have to agree to a slightly higher interest rate.
Like a piggyback loan, run through the numbers to make sure you’re not paying more over the long term at a higher interest rate than PMI.
Pay off your balance quickly. Traditional mortgage lenders typically add a PMI to your loan when your loan-to-value ratio is greater than 80%, but eventually your loan balance should fall below that threshold. Lenders are required by law to automatically remove the PMI once your LTV reaches 78% based on original loan and home values.
If you’re anticipating a significant hit or cash flow to make additional payments, it could help reduce your loan balance faster and get you to the point where you no longer need the insurance.
If you’re working on paying off your balance and think your home’s value has gone up and you’re at or below 80%, you can get a home appraisal. If you’re right, you can request that the lender manually remove the PMI.
Wait until you’ve saved enough. While there are ways to buy a home now and avoid PMI, it’s best to wait until you have enough cash for a 20% down payment.
Saving the 20% you need to avoid PMI can take years. But if you think you can save money fast enough, it may be worth the wait.