All mortgages with the exception of VA Loans, require private mortgage insurance (PMI) unless you make a 20% downpayment.
PMI on a mortgage can add several hundreds of dollars to the payment per month. However, there is one way you can avoid PMI without 20% down.
Some lenders offer a piggyback mortgage, called the 80 10 10 loan. Which means you will receive two loans, one for 80% of the value of the home and one for 10%.
These two loans cover 90% of the purchase price, with the borrower paying the remaining 10% as a downpayment.
What is PMI?
Private mortgage insurance reimburses lenders for their losses sustained because of defaults by borrowers. When a borrower defaults on a loan, PMI will cover the remaining loan amount making the loan less risky for the lender. You pay the premium, but the direct benefit goes to the mortgage company.
According to FreddieMac, PMI typically costs from $30 to $70 per month for every $100,000 you borrow. Bankrate.com says the annual premium generally runs between 0.3 percent and 1.5 percent of the amount your borrow. Thus, if you borrow $240,000, PMI costs $720 to $3,600 annually. This would translate to a monthly amount of $60 to $300 per month.
How a Piggyback Loan works
The First Loan
Your main loan represents 80 percent of the purchase price. For example, on a $300,000 house, you borrow $240,000. The bank gets a first lien on the residence. Should there arise a foreclosure, the primary lender gets paid from the sale proceeds before others.
The Second Loan
In the second prong of the 80 10 10 mortgage, you borrow ten percent of the home’s price. For a $300,000 loan, your loan is $30,000. Some lenders offer a home equity line of credit (HELOC). The second mortgage assumes a junior position to the 80-percent loan. If the second lender forecloses, it receives its money, if any, only after the first lender is paid.
With a piggyback mortgage, your cash down payment stands at ten percent of the purchase price. In our $300,000 home example, you would bring $30,000 in cash to the closing.
An 80 10 10 mortgage cuts in half the amount of cash required from you at closing. Turning back to our $300,000 house, you only need $30,000 of your own cash for the keys. Otherwise, unless you’re willing to pay PMI, your down payment would stand at $60,000, or 20 percent of the price.
The Consequences of having a Second Loan
In a foreclosure, the senior loan gets paid first. When a foreclosure ensues, the home may have lost value. Also, distressed sales such as foreclosures tend to fetch less money than a traditional, negotiated sales transaction. Thus, the junior mortgage holder often has, at best, small prospects for getting anything.
Higher Bar to Qualify
Piggybacking does not come easy. Remember, in a foreclosure, the second lender doesn’t get paid until after the first one.
As a result, you’ll likely need a credit score of at least 700 to qualify. Judgments, delinquent payments, a bankruptcy and other credit problems can derail your piggyback plans.
A piggyback loan also has stricter debt-to-income ratio guidelines. This ratio compares all your monthly debt payments to your monthly income. For example, if you have a ratio of 30 percent, you have 30 cents of debt for every dollar of income.
On a primary mortgage, your debt-to-income ratio generally should not exceed 36 percent. Lenders on piggyback mortgages prefer a debt-to-income ratio at no higher than 43 percent.
The second loan carries a higher interest rate than the first. Depending on the rate, the piggyback loan’s interest could erode part of your savings from avoiding PMI. Also, as to interest:
*Often, the second loan is interest-only on regular payments. To reduce principal, you must make more than the minimum payment.
*Interest rates change throughout the life of a second loan. The rate varies with changes in the prime interest rate. An upward move translates to higher interest payments.
Tax Effects of 80/10/10 piggyback loans
A second set of interest payments can yield tax relief. If you itemized, you can deduct the interest on up to $100,000 on a second loan.
In past years, mortgage insurance premiums were tax deductible. Although that break expired after 2016, Congress is considering making PMI premiums permanently deductible.
Alternatives to Piggyback loans
If you can’t feasibly do an 80 10 10 mortgage, explore down payment assistance programs. Qualified home buyers can access federal, state or local government help, such as:
*Grants, which do not require payback if you live in the home for a specific time period
*Second mortgage homes carrying little or no interest, with the ability to delay payments
*Tax credits for mortgage payments.
Through the National Homebuyers Fund, you can obtain a grant for a down payment of up to five percent of the loan.
A 80/10/10 Piggyback loan can help you avoid PMI obligations, lowering your monthly mortgage payment and your down payment. Ultimately, choosing an 80 10 10 package involves considering trade-offs and your financial situation.