Investing in real estate is a reliable way to build equity and financial security. The most common path to homeownership includes taking out a mortgage loan. Some savvy home buyers opt for piggyback loans in order to avoid paying private mortgage insurance (PMI). As appealing as that sounds, there are a few considerations you should weigh before taking out a piggyback loan.
Piggyback Loans, Defined
Before you can understand what a piggyback loan is, you should know what a second mortgage means for a borrower. A second mortgage is a loan with rights that are subordinate to a first mortgage. So, for instance, if a person has two mortgages on a home that they want to sell, the first mortgage would get paid off before the second mortgage. Typically, borrowers will opt for a second mortgage later on in the first mortgage loan life to pay off credit card debt or another financial hardship. Piggyback loans, also known as 80/10/10 loans, are different.
Simply defined, a piggyback loan is the term used by mortgage lenders when a borrower takes out a first and second mortgage at the same time, often to avoid paying PMI, higher interest rates or avoid taking out a jumbo loan. The first mortgage will typically cover 80% of the purchase price as a traditional 30-year fixed rate mortgage without the usual private mortgage insurance. The second mortgage, the piggyback, will cover 10% of the home price, usually as a home equity line of credit (HELOC). The remaining 10% of the home price is a cash down payment by the borrower.
Things To Consider Before Taking Out A Piggyback Loan
As with most financial decisions, the right choice boils down to your current financial wellness and how to best meet your goals. Let’s take a look at some of the pros and cons of piggyback loans.
Pros Of Piggyback Loans
One of the most common reasons to get a piggyback loan is to avoid paying private mortgage insurance (PMI), which protects the lender from default. It’s cheaper for the homeowner to get two mortgages and the interest is usually tax deductible. We recommend checking with your tax advisor before making such a big financial decision.
When you have 20% equity or more in the home, you are legally allowed to tell your lender to drop PMI. Otherwise, the lender is required to drop PMI when you’ve reached 22% equity in the home.
Lower Down Payments
It can also be a way to finance more than 80% of the home’s purchase price (also referred to as 80% loan-to-value or LTV). For instance, if a home buyer only has enough for a 5% down payment, they can get what’s known as an 80/15/5. The “80” refers to the first mortgage which finances the first 80% of the home’s purchase price. The “15” refers to the second mortgage which finances another 15% of the purchase price. The “5” is the borrower’s 5% down payment. There are two basic permutations to this: 80/15/5 or 80/10/10, however, some lenders do allow an 80/20 in which the second mortgage covers the rest of the purchase price with no down payment.
Getting a piggyback loan can be a nice convenience to home buyers, as it closes at the same time as the first. So, you don’t have to go to two closings and sign two separate sets of paperwork. If your primary lender doesn’t offer piggyback loans, they’ll likely recommend another lender that they have an established relationship with, again, for convenience’s sake.
Sometimes, the second loan can be structured in a way that gives the homeowner practical use. For instance, if the second loan is a home equity line of credit, the homeowner may draw from the loan to use for, say, home improvements.
They may also be structured to allow interest-only payments. This means that for a specified period of time, you only have to pay the interest, though you can add as much principal on top of that as you wish. It gives homeowners the added flexibility in what they can do with their money. They may divert it toward their 401(k) or other financial investments, paying off high-interest credit card debt, saving for a rainy day or what have you.
Avoiding Jumbo Loan Interest Rates
If you’re in the market for a more expensive home, you may be able to avoid the lending limits of jumbo loans. Let’s say your local laws have a lending limit of $500,000. You can put $60,000 down on a $600,000 home but need to finance the rest. Instead of opting for a jumbo loan with high interest, the borrower can take out a piggyback loan of $40,000 to cover the difference. You’ll benefit from lower interest rates on the first mortgage.
Cons Of Piggyback Loans
On the flip side, there are plenty of drawbacks that can turn a borrower off from piggyback loans. Here are just a few:
- Higher interest rates: The second mortgage is usually financed at a higher rate than the first mortgage since it’s tied to short-term interest rates. In fact, these rates may outweigh the cost of PMI over time.
- Higher monthly payments: Second mortgages have a shorter loan term than first mortgages and are usually confined to primary residences. That means higher monthly payments and residence type restrictions.
- Amount limits: They are also limited to amounts no higher than $100,000. However, there are lenders that allow more. Other lenders, like Rocket Mortgage®, do not offer piggyback loans.
Piggyback loans have several benefits, but whether or not getting one is right for you is ultimately your decision. Taking out a piggyback loan can strain your lines of credit, so you’ll want to be sure that the savings are worth it in the long term. If you’re determined to avoid paying PMI premiums, consider buying a more affordable home or researching down payment assistance programs.
If you’re buying a home and are not sure if you need a piggyback loan, it’s best to talk to your mortgage banker. Rocket Mortgage® is here to help with expert advice on your lending needs every step of the way. While we don’t offer piggyback loans, we can help find the right mortgage option for you.