Here’s a dirty little secret: Most people don’t put down 20% when buying a home. Although there are plenty of articles that will scare you into thinking you can’t buy without a flush bank account, it’s simply not true.
Here’s another secret: You have options. Buyers with less than 20% down can pay private mortgage insurance (PMI), choose a loan with a higher rate, or finance with a “piggyback” mortgage.
The bad news? There isn’t a secret mortgage sauce. The best choice depends on your budget, your financial discipline, and your risk tolerance. Before making any big financial decisions, talk to your broker to learn about available mortgage products that might suit your budget.
To get you started, here’s a quick explainer on piggyback loans.
What is a piggyback loan?
Borrowers with a 5% to 15% down payment can finance their home purchase with two loans. The piggyback loan is a second lien behind their first mortgage. The first loan is a more traditional mortgage with an 80% loan-to-value ratio (LTV), while the second lien is a revolving line of credit in the form of a home equity loan.
Payments on piggyback loans vary, as each lender structures the loans differently; these loans are typically pegged to the prime rate (the lowest rate of interest available). Since that rate varies over time, so can the piggyback loan’s monthly payment.
“When you get a piggyback mortgage, the payment is interest only,” says Ray Rodriguez, regional sales manager at TD Bank.
Most have a draw period of about 10 years, during which only interest payments are required. But keep in mind you can make payments towards the principal during this time to help reduce your payments once the draw period ends. After the draw period ends, the outstanding principal is either amortized over a period that can last up to 20 years or due in a lump sum as a balloon payment. In the case of a balloon payment, it takes discipline to pay additional amounts toward the principal balance before it’s due, but it’s necessary to avoid a big shock to your bank account.
If it all just seems like a lot of work, consider the potential upside of having a piggyback loan: It lets you avoid paying PMI, which can be an expensive line item on your monthly budget, and might allow for faster repayment, with some tax benefit.
Is the interest rate on a piggyback loan the same as other mortgages?
The piggyback loan is a home equity loan or line of credit (HELOC). The rates for these are usually based off the prime rate plus a margin, while 30-year fixed-rate mortgages tend to follow the 10-year Treasury or cost of funds.
“The difference [in interest rates] between the HELOC and first lien is 0.75% at present,” says Rodriguez. “The HELOC interest rate is usually lower than the first lien at present.” If interest rates rise as they’re expected to do, HELOC rates might rise above those for a fixed-rate first-lien mortgage. (Interest rates vary by lender too.)
By calculating the blended rate, which is a weighted average of the interest rates for the two mortgages, you’ll be better able to understand the total cost. HELOC rates do change over time, however, as they’re pegged to the prime rate, and a borrower’s rate is determined by various factors, such as credit score, income and assets, loan balance, and LTV ratio.
Is there a difference in payments between piggyback loans and traditional mortgages?
A homebuyer with a 10% down payment could finance with one mortgage (and pay required PMI) or choose to go with two loans: a sizable first mortgage with a piggyback lien that covers the rest.
It’s likely that the first mortgage option will have a slightly higher monthly payment in the early days of the loan. But why?
Two factors contribute to the payment difference. The first is the mortgage insurance, which can be upward of $100 per month, says Rodriguez. Mortgage insurance premiums vary and are calculated as a percentage of your loan balance. This percentage ranges from 0.45% to 1.05% for FHA loans, with an upfront premium of 1.75% of the initial mortgage balance, based on your LTV, loan amount, payment term, and credit.
“The second factor is, when you have a piggyback, you’re only paying interest (not principal and interest), and that’s what gets you a lower monthly mortgage payment,” he adds.
Even with a lower monthly mortgage payment, you’re not off the hook for the money you borrowed with the piggyback loan. Paying your piggyback mortgage without adding in funds toward the principal is kind of like making minimum payments on a credit card balance transfer with a 0% introductory rate. Sure, you’re making payments. (Hooray!) But you could be making them work a heck of a lot harder for you.
If you’re disciplined enough to put that monthly “savings” toward paying down the principal on your piggyback loan, depending on interest rates, you could pay down the loan in eight to 10 years.
One other major consideration? Interest paid on a piggyback loan is tax deductible, and while it’s possible the current tax deduction on mortgage insurance payments will be extended, it’s no sure bet. It’s also worth noting that the second lien will likely limit your ability to borrow additional funds against your home and could complicate a home sale later down the road.
Bottom line: Piggyback loans are best for savvy consumers who possess both risk tolerance for fluctuating interest rates and a disciplined approach to repayment.