Combination Loan: What You Need To Know
Need to buy a house but don’t want to pay for private mortgage insurance? Or maybe you’re building a house and you need to fund the construction of your new dream home? A combination loan might help you reach your goals. While Rocket Mortgage® does not offer combination loans, it’s important to understand what they are if you’re seeking this type of financing.
What Is A Combination Mortgage?
A combination loan is really two separate loans, both issued by the same lender. The loans that make up this combination, though, vary depending on whether you’re building a home or buying an existing one.
When building a home, you’ll take out a construction loan and then a standard mortgage loan. When buying an existing home, you might take out a standard fixed-rate mortgage and a smaller second loan to help you avoid paying for private mortgage insurance.
How Does A Combination Loan Work?
If you’re building a home, you’ll first take out a construction loan that pays your builder while it is overseeing the construction of your new residence. This is often an adjustable rate mortgage, one with an interest rate that fluctuates based on the performance of whatever economic index it is tied to.
Once construction crews finish building your home, your lender will provide you with a standard mortgage loan, often a 30-year mortgage with a fixed interest rate. This loan will replace the construction loan. You’ll use the funds from the new loan to pay off that first loan, and you’ll then make monthly payments, with interest, on your new mortgage until you pay it off.
Combination loans work differently when you’re buying an existing home. Borrowers turn to these loans – often referred to as piggyback loans – when they want to avoid paying private mortgage insurance, or PMI.
PMI is charged by lenders to protect them in case you stop making your mortgage payments. Borrowers don’t like paying for this insurance because it only protects lenders, not borrowers. It can also be costly: PMI varies, but usually costs from 0.1% – 2% of your loan amount every year. It can add hundreds of dollars to your monthly mortgage payment then. You can get rid of PMI after you’ve built up 20% equity in your home.
Lenders charge PMI on conventional loans when borrowers don’t come up with a down payment of at least 20%. Taking out a combination loan can help borrowers avoid PMI even if they can’t come up with that large of a down payment.
Borrowers often achieve this goal by taking out an 80-10-10 piggyback loan. In this type of loan arrangement, borrowers take out a first mortgage, usually a 30-year or 15-year fixed-rate loan, that covers 80% of the home’s purchase price. They take out a second mortgage loan, usually with a higher interest rate, that covers an additional 10% of the home’s purchase price. They then provide a down payment of 10%.
Borrowers, then, make two separate payments each month to their lender, paying off both their first mortgage covering 80% of the home’s purchase price and the second, smaller, mortgage that covers 10% of the residence’s price. This might be more work, but it can help buyers avoid paying for PMI.
The Pros And Cons Of Combination Loans
Combination loans can be helpful for some borrowers, and the lure of avoiding PMI is enticing. It’s important to know, though, that combination loans do come with some drawbacks, too.
Pros Of Combination Loans
- Avoid private mortgage insurance (PMI)
- The main benefit of a combination loan is that you can avoid paying for PMI, even if you can’t come up with a down payment of 20% of your home’s purchase price. For more information about PMI, check out our story “What Is PMI Insurance And How Do I Avoid It?”
- Avoid getting a jumbo loan
- A jumbo loan, as its name suggests, is a mortgage loan that is larger than usual. Each year, the Federal Housing Finance Administration, or FHFA, sets conforming loan limits for mortgages that will be acquired by Fannie Mae or Freddie Mac. If you need a loan that is higher than that limit, you’ll need to apply for a jumbo loan. In 2022, the FHFA's conforming loan limit for one-unit properties is $647,200 for most of the country. In higher-cost areas of the United States, though – places like New York City and San Francisco – the FHFA conforming loan limit for 2022 is $970,800. If you need a mortgage for more than these amounts, depending on where you live, you'll need to take out a jumbo loan, which typically comes with higher interest rates. By taking out a combination loan, you might be able to avoid a single, more expensive, jumbo loan. For more information, check out our story “Jumbo Loan: Definition, Rates And Limits.”
Cons Of Combination Loans
- Double the loan servicing fees
- This might vary by lender, but because you’re taking out two mortgage loans, you might have to pay two sets of servicing fees when you need to do things such as order documents from your lender or verify your mortgage. For more information about servicing fees, check out our story “Servicing Fees And How To Avoid Them.”
- Manage two loan payments
- Two loans means you’ll be making two loan payments. You’ll have to manage not one but two mortgage payments each month. Depending on your organizational skills, this could be challenging.
- May pay more for loan interest than PMI
- The second loan in a combination mortgage typically comes with a higher interest rate. If that rate is too high, you might spend more with a combination loan than you would with a single mortgage with PMI. You’ll need to do the math to determine which choice is less expensive.
Alternate Options To A Combination Loan
A combination loan isn’t the right choice for everyone. In fact, there are other loan types that might save you more money, thanks to lower interest rates, even if you do have to pay some form of mortgage insurance.
USDA And VA Loans
Both USDA and VA loans are attractive because they don’t require down payments. There is a catch, though: Not everyone can qualify for these loans. To qualify for a VA loan, insured by the U.S. Department of Veterans Affairs, you’ll need to be a member or veteran of the U.S. Military or the widowed spouse of a military veteran who died because of his or her service. To qualify for a USDA loan, insured by the U.S. Department of Agriculture, you need to buy a home in a rural part of the country.
VA loans don't require PMI, which is one definite benefit. But you will have to pay a one-time VA funding fee. This fee usually costs 2.3% of your loan amount, but it could range from 1.4% to 3.6% depending on whether you do come up with a down payment and whether this is your first or a subsequent VA loan.
USDA loans don't require PMI, either, but you will have to pay two other fees when taking out one of these loans. You'll pay an upfront guarantee fee equal to 1% of your loan amount and an annual fee of 0.35% of your loan amount each year. You'll pay the annual fee until you pay off your mortgage, refinance into a different mortgage type or sell your home. You'll have to determine, then, if the benefit of not having to come up with a down payment outweighs the cost of this annual fee.
FHA loans, insured by the Federal Housing Administration, are attractive, too, because if your FICO® credit score is at least 580, you’ll only have to come up with a down payment of 3.5% of your home’s purchase price.
FHA loans also don’t require PMI, though they do require two Mortgage Insurance Premiums, one that you'll pay when taking out your loan and another that you'll pay each year. The upfront Mortgage Insurance Premium is 1.75% of your loan amount. The FHA's annual Mortgage Insurance Premium varies depending on the loan-to-value ratio of your loan and the term of your mortgage. Most FHA borrowers, though, pay an annual Mortgage Insurance Premium of 0.85% of their loan amount. This premium remains in place throughout the life of your loan.
Conventional mortgage loans are not insured by a government agency. Most mortgages originated in the United States, then, are conventional. The credit score and debt requirements needed to qualify for one of these loans vary by lender, but you can generally qualify for a conventional mortgage if your FICO® score is at least 620 and your monthly debts, including your new mortgage payment, consume no more than 43% of your gross monthly income.
You don’t need a 20% down payment to qualify for a conventional loan. Some conventional loan programs allow you to put down just 3% of your home’s purchase price. Remember, though, if you come up with a down payment that is less than 20% of your home’s price, you will have to pay PMI.
The Bottom Line
If you’re ready to buy a home, it makes sense to consider all mortgage loan types, including combination mortgages. Remember, though, that these loans do come with some drawbacks and that conventional or government options might be a better choice. If you want to learn more about how you can avoid private mortgage insurance, review our guide to PMI. Your best move is to talk with a Home Loan Expert to determine which type of home loan best fits your needs.