Piggyback mortgages. also known as an 80-10-10 mortgage or blended mortgages have been around for a few years and are increasingly a force in the home buying arena. This has triggered warnings about their risk and proposed legislation to neutralize one of their key marketing advantages.
A piggyback loan is basically a second mortgage given at the time of a home purchase or a refinance. Its purpose is to allow the home buyer to acquire or refinance a home with less than a 20 percent down payment (or equity) but without the necessity of carrying private mortgage insurance (PMI). While there are many variations, a typical definition of a piggyback is a 10 percent second mortgage coupled with a traditional 80 percent first lien and a 10 percent down payment, hence the 80-10-10. But piggybacks can conceivably make up the difference between a conventional loan and almost any amount of down payment - an 80-5-15 for example. The first and second mortgages are closed simultaneously and the same loan officer usually handles the paperwork for both. Homeowner acceptance of piggyback loans coupled with aggressive marketing of the product by loan officers has caused substantial inroads on the business of private mortgage insurers.
A down payment of less than 20 percent has traditionally marked a loan as "risky." Lenders want that 20 percent cushion to ensure that the collateral - the house - will be sufficient to cover the debt in the event of foreclosure. Lenders fear a loan to value (LTV) of 85 or 95 percent may not allow full recovery if the housing market declines or if the property in question loses value through deferred maintenance or a localized situation (a new Interstate off ramp across the street for example.) Lenders also consider a buyer without significant investment in the property to be a higher personal credit risk. Therefore, buyers with only 5 or 10 percent for a down payment have typically been required to carry PMI until their equity in the home reaches the magic 80%.
PMI policies are written by a number of private companies and, even though the premiums are paid by the borrower, PMI protects the lender. In the event of a default PMI does not make mortgage payments but steps in to make the lender whole or nearly whole if a foreclosure does not fully repay the loan.
For example. a bank agrees to write an $180,000 mortgage on a house that is valued at 200,000 (90 percent LTV) and requires private mortgage insurance. In less than a year the homeowner defaults and the bank forecloses. In the meantime the homeowner has started several home renovation projects that never got past the demolition stage and the home is a wreck, bringing only $165,000 at the foreclosure auction. The bank also incurred some $6,000 in legal and other foreclosure expenses. The bank will file a claim with the private mortgage insurer for the difference between the original LTV and 80 percent, in this case recovering an additional 10 percent or $20,000 and losing only $1,000 on the loan.
PMI costs are high. The premium on a $100,000 mortgage with 5 percent down will be between $40 and $45 per month. PMI rates vary according to the length and type of loan and the LTV. For example, a recent study
found that a $100,000 30-year fixed loan with 15 percent down would have a premium of 0.32 percent or $27 per month while a 1-year ARM with a five percent down payment would carry a premium of $97.50. At least part if not all of the entire first year premium is required at closing, increasing the amount of cash necessary at a time when cash is at a premium. Payments for subsequent years are collected each month and escrowed the same as taxes and homeowners insurance.
Borrowers have complained for years that it is nearly impossible to eliminate PMI. The Homeowners Protection Act of 1998 has helped change that a bit. The law requires that, for all loans made after July 29, 1999, PMI must be removed once a homeowner pays down his loan to a point where he has 22 percent equity. A good payment history is required to invoke this rule and the presence of a junior lien may invalidate it altogether. Information varies on loans made prior to the 1999 date; some say they are usually cancelled when the LTV reaches 50 percent, others when the loan is halfway through the amortization period. With most loans this would mean 180 monthly premium payments, but many lenders have declared their intent to apply the new rules to older loans.
But notice, the PMI law requires that the mortgage be paid down to that 78 percent LTV. Homeowners have complained that, even as the value of their homes and consequently their equity has skyrocketed, lenders drag their heels and require substantial proof of equity from borrowers when asked to remove the PMI requirement. Borrowers frequently have to pay $300 to $400 for an appraisal as part of that proof.
Defenders of PMI maintain that the insurance helps homeowners buy a home much sooner than if they had to accumulate a 20 percent down payment and that those with significant cash can move up and invest in more expensive homes. They also condemn piggyback mortgages as limiting a home owner's flexibility to refinance or take out a home equity line and say that, while PMI goes away when sufficient equity is obtained, the piggyback, like most second mortgages, can hang around for ten to 15 years.
Those on the side of the piggyback loan say that the extra payment each month is going toward building equity rather than paying an insurance premium from which they will never receive a benefit. And best of all, second mortgage payments, unlike PMI premiums, are tax deductible .
Private mortgage insurers, feeling the pinch of lost business, are now attacking piggyback mortgages on that last point. Two bills are currently pending before Congress - House Resolution 3098 and Senate Bill 132 - which would amend the Internal Revenue Code of 1986 to allow homeowners to deduct the cost of PMI premiums in the same way that they now deduct home mortgage interest. The bills are currently awaiting hearings in the appropriate committees.
If that tax advantage goes away, are piggybacks still a good idea? A couple of studies indicate that such loans carry a higher degree of risk. We will take a look at one or two of these and a closer look at the presumed financial advantages of these blended mortgages in a subsequent article.