Piggybacks Arouse Interest - And Concern
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Piggyback mortgages, also known as an 80-10-10 mortgage
or blended mortgages have been around for a few years and are increasingly a
force in the home buying arena. This has triggered warnings about their risk
and proposed legislation to neutralize one of their key marketing advantages.
A piggyback loan is basically a second mortgage given at the time
of a home purchase or a refinance. Its purpose is to allow the home buyer to
acquire or refinance a home with less than a 20 percent down payment
(or equity) but without the necessity of carrying
private mortgage insurance (PMI). While there are many variations,
a typical definition of a piggyback is a 10 percent second mortgage coupled
with a traditional 80 percent first lien and a 10 percent down payment, hence
the 80-10-10. But piggybacks can conceivably make up the difference between
a conventional loan and almost any amount of down payment - an 80-5-15
for example. The first and second mortgages are closed simultaneously and the
same loan officer usually handles the paperwork for both. Homeowner acceptance
of piggyback loans coupled with aggressive marketing of the product by loan
officers has caused substantial inroads on the business of private mortgage
insurers.
A down payment of less than 20 percent has traditionally marked a loan as "risky."
Lenders want that 20 percent cushion to ensure that the collateral - the
house - will be sufficient to cover the debt in the event of foreclosure.
Lenders fear a loan to value (LTV) of 85 or 95 percent may not allow full recovery
if the housing market declines or if the property in question loses value through
deferred maintenance or a localized situation (a new Interstate off ramp across
the street for example.) Lenders also consider a buyer without significant investment
in the property to be a higher personal credit risk. Therefore, buyers with
only 5 or 10 percent for a down payment have typically been required to carry
PMI until their equity in the home reaches the magic 80%.
PMI policies are written by a number of private companies
and, even though the premiums are paid by the borrower, PMI protects the lender.
In the event of a default PMI does not make mortgage payments but steps in to
make the lender whole or nearly whole if a foreclosure does not fully repay
the loan.
For example, a bank agrees to write an $180,000 mortgage on a house
that is valued at 200,000 (90 percent LTV) and requires private mortgage insurance.
In less than a year the homeowner defaults and the bank forecloses. In the meantime
the homeowner has started several home renovation projects that never got past
the demolition stage and the home is a wreck, bringing only $165,000 at the
foreclosure auction. The bank also incurred some $6,000 in legal and
other foreclosure expenses. The bank will file a claim with the private
mortgage insurer for the difference between the original LTV and 80
percent, in this case recovering an additional 10 percent or $20,000 and losing
only $1,000 on the loan.
PMI costs are high. The premium on a $100,000 mortgage with 5 percent
down will be between $40 and $45 per month. PMI rates vary
according to the length and type of loan and the LTV. For example, a recent
study found that a $100,000 30-year fixed loan with 15 percent down would have
a premium of 0.32 percent or $27 per month while a 1-year ARM with a five percent
down payment would carry a premium of $97.50. At least part if not all of the
entire first year premium is required at closing, increasing the amount of cash
necessary at a time when cash is at a premium. Payments for subsequent years
are collected each month and escrowed the same as taxes and homeowners insurance.
Borrowers have complained for years that it is nearly impossible to eliminate
PMI. The Homeowners Protection Act of 1998 has helped change
that a bit. The law requires that, for all loans made after July 29, 1999, PMI
must be removed once a homeowner pays down his loan to a point where
he has 22 percent equity. A good payment history is required to invoke
this rule and the presence of a junior lien may invalidate it altogether. Information
varies on loans made prior to the 1999 date; some say they are usually cancelled
when the LTV reaches 50 percent, others when the loan is halfway through the
amortization period. With most loans this would mean 180 monthly premium payments,
but many lenders have declared their intent to apply the new rules to older
loans.
But notice, the PMI law requires that the mortgage be paid
down to that 78 percent LTV. Homeowners have complained that, even as the value
of their homes and consequently their equity has skyrocketed, lenders drag their
heels and require substantial proof of equity from borrowers when asked to remove
the PMI requirement. Borrowers frequently have to pay $300 to $400 for
an appraisal as part of that proof.
Defenders of PMI maintain that the insurance helps homeowners buy a home much
sooner than if they had to accumulate a 20 percent down payment and that those
with significant cash can move up and invest in more expensive homes. They also
condemn piggyback mortgages as limiting a home owner's flexibility to
refinance or take out a home equity line and say that, while PMI goes away when
sufficient equity is obtained, the piggyback, like most second mortgages, can
hang around for ten to 15 years.
Those on the side of the piggyback loan say that the extra payment each month
is going toward building equity rather than paying an insurance premium from
which they will never receive a benefit. And best of all, second mortgage payments,
unlike PMI premiums, are tax deductible.
Private mortgage insurers, feeling the pinch of lost business, are now attacking
piggyback mortgages on that last point. Two bills are currently pending before
Congress - House Resolution 3098 and Senate Bill
132 - which would amend the Internal Revenue Code of 1986
to allow homeowners to deduct the cost of PMI premiums in the
same way that they now deduct home mortgage interest. The bills are currently
awaiting hearings in the appropriate committees.
If that tax advantage goes away, are piggybacks still a good idea? A couple
of studies indicate that such loans carry a higher degree of risk. We will take
a look at one or two of these and a closer look at the presumed financial advantages
of these blended mortgages in a subsequent article.
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