An increasingly common junior loan is the piggyback loan. On conforming loans, lenders are required to have the borrower obtain private mortgage insurance on loans over an 80% loan-to-value ratio. The cost of the insurance is not paid to the lender. The piggyback loan allows the lender to make more money and the borrower, in most cases, to pay less.
The lender offers the borrower two loans. The first mortgage is for 80% loan to value. This does not require private mortgage insurance. A second loan of 5%–20% is piggybacked on the first mortgage to create a mortgage package that allows the borrower to buy the property with less than 20% down, sometimes all the way to 0% down. The second loan is at a higher rate than the first, but usually is less than what the borrower would pay for a first at over 80% with private mortgage insurance. The lender makes money by charging the higher rate on the second loan, in effect becoming the private mortgage insurer.
The other savings to the borrower is that the interest on the piggyback loan is tax deductible, whereas private mortgage insurance is not. (Check with your tax advisor, as this may be changing.) If you are in a situation in which you want to finance more than 80% of the purchase price, ask your potential lender about it. Then, calculate the higher interest rate of the piggyback against the cost of private mortgage insurance. Remember that private mortgage insurance is dropped once you have paid the loan down to under 80% of the loan to value. The higher interest on the piggyback will last for the life of the loan. If you are not sure about your calculations, check with your accountant or simply ask your lender or mortgage broker to figure it out for you.
Another advantage to the piggyback is that it is for a small amount, somewhere from 5% to 20% of your combined loans. This means that by making relatively small additional principal payments, you can pay it off quickly.
There may be other liens against a mortgaged property, such as judgments or IRS tax liens. These may be superior to, or inferior to, any mortgages. If you have judgments or tax liens against you and you are planning to refinance or get a second mortgage loan, you may be required to pay them off first.
Example: Compare two loans with a 10% cash down payment. One is a 90% loan with PMI. The other is an 80% loan with a piggyback loan for another 10%. With the first loan, you have to pay the loan down to 80% before you can get rid of the PMI portion of the payment. The PMI portion of your payment does not reduce your principal balance.
With the second loan, there is no PMI and every payment goes toward reducing your principal balance. If the PMI portion of the payment for the first loan is the same amount as the payment for the piggyback loan, you will have your total outstanding mortgage balance down to 80% much faster.
In most cases, the amount you have to pay each month on the piggyback loan will be less than the amount you would have to pay in PMI. If you take the savings and make additional principal payments on your remaining mortgage, you can substantially reduce the term and the amount of interest over the life of the loan. (Prepayment penalties could ruin this plan, which is why you should always ask about them.)
The piggyback is also useful if you have other assets that you want to keep. If you own high-interest bonds or stock that you really believe will go up, you do not want to sell these assets to come up with a 20% down payment for your home purchase. You may want to get a piggyback loan instead until the stock value goes up. Then, you can sell the stock and pay off the loan. Be sure to find out in advance what it will cost both to get the piggyback and to pay it off. You can then figure out how much your stock will have to go up to make it worthwhile. Your accountant’s advice may help you make the right decision.