Buyers are sometimes torn about how much money to put down a house. Drop too much and you’re in danger of lacking any sort of financial cushion in case of emergency.
Not enough, and you need to either take out a private mortgage insurance (PMI) policy; or, borrow with a piggyback mortgage - consistsing, for example, of one 30-year fixed-rate mortgage that covers 80% of the cost of the home and a second 15-year fixed-rate balloon loan to cover 15% of the down payment.
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We’ve talked about many of these mortgage products at length, but below is a brief breakdown of some of the most common home loan financing products and how they differ from one another. Especially in this lending climate, you can’t be too careful. Read up.
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FIXED-RATE MORTGAGE
Overview: A mortgage with payments that remain the same throughout the life of the loan, because the interest rate and other terms do not change.
Advantages: Predictable payment, you know you will not suffer when interest rates rise.
Disadvantages: An initial interest rate that will be higher than an ARM, as will the mortgage payment itself; no benefit when market rates fall.
ADJUSTABLE-RATE MORTGAGE
Overview: A mortgage loan subject to changes in interest rates; traditional ARMs typically have a fixed period with adjustable period afterwards. That period is generally made up of either 1, 3, 5, 7 or 10 years.
Advantages: Low initial interest rate compared with a fixed-rate mortgage, payments go down when market rates fall.
Disadvantages: No stability, payments change over time, payments increase when home loan rates rise.
BALLOON MORTGAGE
Overview: A balloon mortgage is a loan that typically offers low rates for a short period of time (usually 5, 7, or 10 years); after that, the balance must be paid off or refinanced.
Advantages: Lower rates than fixed-rate mortgages.
Disadvantages: Will need to pay off in short time period, may need to apply for a mortgage refinance at a higher rate than you’d like.
INTEREST-ONLY MORTGAGE
Overview: A mortgage that allows the borrower to pay only on the interest during the first few years of the loan (this model can be either fixed or adjustable rate).
Advantages: Low monthly payments.
Disadvantages: Initial payments do not reduce the principal on the loan.
PIGGYBACK MORTGAGE (or 80/20 LOAN)
Overview: Two loans taken out at once, with the smaller, second mortgage loan usually obtained at a higher rate.
Advantages: Eliminates mortgage insurance (PMI) on the monthly payment, which would be required of you if you did not make 20 percent of the purchase price as a down payment.
Disadvantages: In some cases, the total monthly home loan payment can be higher than with a 100 percent loan plus PMI.
OPTION ARM
Overview: Special adjustable-rate mortgages that allow the borrower to pay a credit card-like minimum payment that is actually less than the interest owed.
Advantages: Flexibility, low monthly payments.
Disadvantages: Possible negative amortization - your debt increases instead of decreases over time, somewhat defeating the purpose of home ownership.
SOURCE: The News-Journal
The following question and answer is courtesy of Bankrate.com. Its financial advisor responds to an inquiry regarding mortgage refinancing of a piggyback home loan:
Q: I recently learned that my credit union is offering a 100 percent, no money down mortgage available at a rate of 7 percent. I currently have an 80/20 mortgage on my home. The 80 percent first mortgage is a 30-year fixed rate at 6.375 percent and the 20 percent second mortgage is a home equity line of credit, at prime plus 2 percent.
Should I consider a second mortgage refinance and take out the one fixed-rate mortgage, as opposed to the two I currently have?
My home is worth approximately $327,000. The home loan balance on the first mortgage is $253,000 and the loan balance on the line of credit is $64,800. I’ve been in the home for two years, and expect to remain in the home for at least two more years.
A: I recommend that you stay with your current loans for a couple of reasons. First, you aren’t sure that you’ll be in the house for very long. Mortgage refinancing can be an expensive proposition. According to Bankrate’s 2006 national survey of closing costs, you should expect to pay somewhere around $3,000 to close that loan.
Second, your existing first mortgage is 5/8 of a percent less than the credit union’s mortgage loan rate. Saving 5/8 of a percent on a $253,000 loan balance doesn’t quite trump saving 3¼ percent on a $64,800 loan, but my guesstimate (below) has only a $525 difference in interest expense in the first year of the refinancing.
If you pay $3,000 to mortgage refinance, then it’ll take about six years to recoup that cost. You’re not sure how long you’ll be in the house, so it’s hard to justify it on that basis.As of February 2007, prime plus 2 percent equals 10¼ percent. That’s expensive for a HELOC, but it’s priced to reflect the lender’s risk when a homeowner has minimal equity in the property.
By your estimate, you have 3 percent equity in the home. I’ll be the first to tell you that I don’t know where interest rates are headed, but the expectation is that the prime rate is at or near its high for this interest rate cycle and its next move is expected to be lower.
Instead of refinancing both loans, focus on making additional principal payments on the line of credit to get to a point where you can refinance that loan at a rate closer to prime.
Closing costs on a new line of credit are measured in hundreds, not thousands, of dollars. That presumes that there’s no prepayment penalty on the line of credit. Check with your lender if you’re not sure about a prepayment penalty.
Today’s Lakeland Ledger contains an article detailing the new tax break for mortgage insurance - and whether it makes sense for homeowners. The results may surprise you.
When she heard about a new tax break for mortgage insurance, Kathryn Considine, who paid $55 a month for it last year, was delighted.
“I thought if I could deduct what I paid this past year, that would be great,” she said.
But she actually won’t get the tax deduction - and neither will anyone - unless the premiums you’re paying are for a home mortgage loan you take out this year.
Even if you qualify, the deduction is good for only one year.
The mortgage insurance deduction, part of the last-minute tax bill Congress passed in December, turns out to be yet another example of tax policy gone wrong.
Here’s a little background:
To reduce their risk of losing money, a mortgage lender usually requires mortgage insurance if you put down less than 20 percent of the purchase price of a home. It pays off if you default.
The drawback: The premiums increase your mortgage payment, typically by $50-100 a month. However, many buyers get around this requirement with a piggyback mortgage deal - an 80 percent first mortgage paired with a 20 percent home equity loan or credit line at a higher interest rate.
This pairing became very popular when short-term home loan rates were low, causing a drop-off in business for mortgage insurance companies.
The industry’s solution was to lobby Congress to make premiums deductible, calling for a more level playing field. Many groups interested in making affordable housing more plentiful supported the effort.
“We are pleased that policymakers have recognized mortgage insurance as a cost of finance just like mortgage interest,” Suzanne Hutchinson, executive vice president of the trade group Mortgage Insurance Companies of America, said.
The association says as many as 2 million families will be buy or refinance an insured mortgage loan next year and be eligible for the tax break. Their incomes must be less than $110,000 a year. No home loan refinancing can be for more than the original loan on the home.
Unfortunately, this new deduction flunks a basic fairness test:
- Why should 2 million families who take out new mortgages get a tax break while millions of others paying mortgage insurance premiums do not?
- And why should mortgage insurance get better tax treatment than property insurance, which also is required by a mortgage company and is much more costly?
The arrangement also flunks a common-sense test:
- No deduction should be added to the tax code for just one year, especially one that is complicated to apply and save people anything significant on their home mortgages.
So why did we end up with what we did? An unfair bill that expires after one year costs a lot less than one that’s more comprehensive and becomes a permanent part of the tax code.
As it is written, the cost to the government is just $91 million in lost tax revenue. But of course that’s a misleading number because the next lobbying effort will be to extend it.
“It was a good way to get the deduction on the books without having to get into how this will impact the federal budget beyond one year,” association spokesman Jeff Lubar said.
At least he’s honest.
Mortgage insurance will be tax-deductible in 2007, and for some homeowners, the new law means it will be cheaper to get mortgage insurance than to get piggyback mortgages.
Hundreds of thousands of homeowners will save a total of $91 million when they file their tax returns in 2008, according to estimates prepared by the mortgage insurance industry.
The bottom line for consumers, according to Holden Lewis of Bankrate.com: Don’t get a piggyback mortgage without taking a serious look at mortgage insurance, because mortgage insurance is likely to be cheaper in the long run, and it might even cost less in the short run.
Here’s a look at how a piggyback loan and mortgage insurance match up:
According to experts, a homeowner with a $180,000 mortgage would save about $351 in taxes per year because of the mortgage insurance law that was just passed. This assumes the borrower has a good credit score and is in the 25 percent tax bracket.
When you buy a house, a mortgage lender considers you a risk if you make a down payment of less than 20 percent. There are two main ways to make you pay for that risk: mortgage insurance and piggyback loans.
Mortgage insurance is the old-school method. You, the borrower, pay for the policy, but the lender is the beneficiary. If you fall behind on the loan payments and the mortgage company has to foreclose, the mortgage insurance policy reimburses the lender for legal costs and lost income.
The premiums depend on the size of the home loan, the percentage of the down payment, your credit score and the type of mortgage insurance you get.
When you use a piggyback mortgage, you get two home loans: a primary loan for 80 percent of the house’s value and a second mortgage for the rest of the money you need. With a 5 percent down payment, you would get what’s called an 80-15-5 mortgage: an 80 percent loan, a 15 percent piggyback and 5 percent down.
In turn, getting a piggyback loan effectively eliminates the need for mortgage insurance. The piggyback can either take the form of a fixed-rate home equity loan or a variable-rate home equity line of credit. The piggyback has a higher rate than the first mortgage.
The combined payments on a piggyback mortgage are a bit less than the payment on a single loan with monthly mortgage insurance premiums. For years, piggybacks had a big advantage because the mortgage interest on both mortgage loans was tax-deductible; mortgage insurance payments were not.
Now that has changed, with these caveats. The tax deduction applies only to home mortgages that are closed in 2007. If you currently have a home mortgage loan with mortgage insurance in 2006, you won’t be able to deduct the premiums in the 2007 tax year unless you refinance in 2007.
There are income limits. You get the full deduction if your adjusted gross income is $100,000 or less. The amount you can deduct phases out rapidly after that, and no mortgage insurance deduction is available if you make more than $110,000.
This is a one-year deal, and Congress would have to renew the deduction to make it apply for the 2008 tax year and beyond. Of course, if you opt to take the standard deduction instead of itemizing deductions, the new mortgage insurance tax credit makes no difference to you.
When you put those complications aside, the new law makes it easier to compare loan offers. Everything is now on equal footing. Mortgage insurance is tax-deductible and piggyback mortgages are tax-deductible.
Have you already decided to buy a home? The only remaining question: How should you finance it?
Let’s say you’re looking into a $400,000 with a 30-year fixed-rate mortgage. Perhaps you can afford a 20% down payment - but will you save money by keeping that cash tied up in investments?
Is it a better choice to look into 100% financing with a product such as an 80/20 piggyback home loan? Or should you take funds out of other areas and put them into a down payment along as part of a typical mortgage package? Let’s discuss these options.
Taking a 100 percent loan with a piggyback - a first mortgage for 80 percent of value and a second mortgage for 20 percent - would result in a higher overall cost than an 80 percent loan with a 20 percent down payment. In part, the higher cost will be in the higher rate on the second mortgage. But in addition, either the rate on the first mortgage will be higher, or the total loan fees will be higher.
The intent, in the scenario above, is to invest the $80,000 that would otherwise go into a down payment. But a down payment is also an investment.
The return consists of the reduction in upfront costs, lower interest payments in the future, and lower loan balances at the end of the period in which you expect to be in the house. Determine the annual rate of return on investment in the case cited above with a mortgage calculator, assuming you intended to be in the house for seven years. It was 15.6 percent before tax, and it carries no risk. Investments that good are not available in the marketplace.
Why is the return so high? When you take a 100 percent home purchase loan, even though you have the capacity to make a down payment, you place yourself in the same risk class as borrowers who have not been able to save for a down payment, those who have negative equity in their house the day they move in.
The default rate of such borrowers is relatively high; they pay for it in the price of the piggyback (or in mortgage insurance); and you pay the same price as them. This is a situation you should try to avoid if you can afford to do so.
As you try to determine the best home loan for your needs/goal - with options available that range from basic fixed-rate mortgage products to an interest-only mortgage - consider a piggyback loan.
We’ll review a few of the most common questions surrounding this resource below.
Q: What is a piggyback mortgage?
A piggyback mortgage is actually a package of two loans, one added on top of the other. For residential properties, that usually means a first mortgage which covers 80% of the value of the property, plus a second lien which covers 10%, 15% or even the whole remaining 20% of the value of the home.
The second loan - which can be either fixed or an adjustable-rate mortgage - is “piggybacked” on top of the first loan.
Q: What’s the point? Why not simply take one mortgage for 90%, 95% or even 100% of the value of the property?
A little (short and simplified) mortgage history may be helpful here.
In the past, if you had less than 20% of your own money to put up, financing probably wasn’t available to you. Naturally, the less of your money you put toward the purchase of your home, the more risk the lender needs to shoulder.
Mortgages with small down payments represent a greater risk to the lender/investor because a borrower with a lesser interest in the property may simply walk away (default) in the event of severe financial trouble.
Mortgage insurance, or MI, helps to indemnify the lender/investor by covering a portion of the value of the property. If the borrower defaults, the MI will usually cover the costs of foreclosing on and repairing the property, as well as the costs for selling it.
Typically, if the lender must accept more risk, you’ll pay a higher rate, higher fees, or both - a sort of “risk premium.” Back in the day, lenders were not eager to make loans in excess of an 80% Loan-to-Value ratio, since they couldn’t easily be sold to the secondary market; essentially, the lender would have to keep your loan, and all of the risk of delinquency or default, for the entire term.
Q: Which is better - A piggyback, or a traditional loan with MI?
Either method has both advantages and drawbacks. For example, MI may be cancelable after a fairly short period of time through no effort on your part, aside from making your regular monthly payments. That is, if the value of your home has risen sharply, you may be able to cancel MI in just two years.
You have no such option for the second lien arrangement, though; you signed on for a given number of payments to retire the lien, and that cannot be changed without a slug of cash to pay off the loan (or a mortgage refinancing).
Of course, if you’re not diligent about making your payments on time, your mortgage lender can refuse to cancel your MI. You could always refinance, of course, although rates may not favor you. On the other hand, even if you’re late occasionally with payments on your second home loan, it will still have a fixed termination date and a known cost.
As we mentioned above, there can be tax benefits for a second lien versus MI situation, at least on a comparable basis, but only if you itemize on your tax return.
