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Piggyback Mortgages and PMI

Dollar Stretcher (featured column)
by Gary Foreman

Q: We have a new home under construction.  After paying off debts we don't have enough for the 20% down payment to avoid PMI. I am trying to compare a low fixed rate 30 year mortgage to an 80/15/5 mortgage where the PMI is waived. Is an 80/15/5 mortgage a good deal for the borrower or just for the lender? Most of the info I found was from brokers. It is hard to be too confident about their information since they are selling the product. - Rob in Texas

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A: Like many people, Rob is anxious to enter the housing market. Low interest rates make mortgages more affordable. But they also drive up housing prices. Which means more people are having trouble saving an adequate down payment.

Let's begin with a couple of concepts. Private mortgage insurance (PMI) helps people to buy homes when they have a small down payment. PMI does not protect the homeowner even though they pay for the insurance. It covers the mortgage company if the borrower stops paying.

PMI may require an initial payment and/or a regular monthly payment. A smaller down payment means a higher PMI premium. Typically, the homeowner is allowed to cancel PMI after they have equity in their home of 20%. They can build equity by paying down principal or by seeing the value of the
home appreciate through rising prices. As you would expect, everyone wants to stop paying for PMI as soon as they can.

Which brings us to the "piggyback" or combination mortgage. How does it work? The first mortgage company provides a mortgage for 80% of the property. A second mortgage company that doesn't require PMI grants another mortgage for 15%. That leaves the buyer to come up with the final 5% as a down payment. It's like getting a 95% mortgage without PMI. Thus the 80/15/5 description.

There are some variations on the piggyback. Some are 80/10/10. Others even ask the seller to come up with the final 10% so that the buyer needs no money down.

Why would Rob use a piggyback? Mortgage payments are tax deductible. PMI payments are not. If you pay off your 2nd mortgage early, you can reduce your monthly payment. Sometimes the seller is willing to carry the second mortgage at rates lower than traditional lenders.

But, Rob is right. There are some disadvantages that often get overlooked. Second mortgage rates are typically higher than those charged on first mortgages. It's possible that the combined mortgage payments could be higher than a single mortgage plus PMI payment.

The second mortgage will have a second set of costs associated with it. Some even carry a prepayment penalty.

And, second mortgage payments will continue until that loan is paid off. PMI can be cancelled when your equity reaches 20%.

Rob also should beware of 'balloon payments' on the second mortgage. He may be offered a loan that's amortized over 30 years. In other words, the payments are calculated as if you'll be making them for 30 years. That makes for low monthly payments. But at some point in the future (usually 10, 15 or 20 years) the balance of the loan is due. That balance is the 'balloon'. And the homeowner is required to come up with the cash or refinance at that point.

So which is best? In part it will depend on the rates that Rob will be offered on first, second and PMI. He'll also need to consider how long it will be before he has a 20% equity in the home and can cancel PMI. Rob can take that info and estimate what his payments will be in future years. Unfortunately predicting the future isn't an exact science. So there is no one correct answer.

Finally, a warning to Rob and others with small down payments. Housing prices can decline. When interest rates rise people will not able to afford as much housing. For instance, if rates rise from 6% to 7%, a buyer can only spend 90% of what he could at the lower rate. So the check that paid for a $200,000 mortgage now becomes the payment for a $180,000 loan. That could hold down home prices.

Many people are familiar with the concept of being 'upside down' in a car loan. That's where they owe more money than the car is worth making it difficult to sell or trade the car.

Being upside down in a mortgage could be significantly more painful. Imagine that you've lost your job and need to move to a new city to regain employment. But the only way that you can sell your home is to bring a check for $10,000 to the closing because you owe more than it's worth. For many that would be an impossibility. So please move cautiously if you're buying with a minimal down payment.

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Copyright © 2005 by Gary Foreman. All rights reserved.

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