Like many people, Rob is anxious to enter the housing market. Low interest
rates make mortgages more affordable. But they also drive up housing
prices. Which means more people are having trouble saving an adequate down
Let's begin with a couple of concepts. Private mortgage insurance (PMI)
helps people to buy homes when they have a small down payment. PMI does not
protect the homeowner even though they pay for the insurance. It covers the
mortgage company if the borrower stops paying.
PMI may require an initial payment and/or a regular monthly payment. A
smaller down payment means a higher PMI premium. Typically, the homeowner
is allowed to cancel PMI after they have equity in their home of 20%. They
can build equity by paying down principal or by seeing the value of the
home appreciate through rising prices. As you would expect, everyone wants
to stop paying for PMI as soon as they can.
Which brings us to the "piggyback" or combination mortgage. How does it
work? The first mortgage company provides a mortgage for 80% of the
property. A second mortgage company that doesn't require PMI grants another
mortgage for 15%. That leaves the buyer to come up with the final 5% as a
down payment. It's like getting a 95% mortgage without PMI. Thus the
There are some variations on the piggyback. Some are 80/10/10. Others even
ask the seller to come up with the final 10% so that the buyer needs no
Why would Rob use a piggyback? Mortgage payments are tax deductible. PMI
payments are not. If you pay off your 2nd mortgage early, you can reduce
your monthly payment. Sometimes the seller is willing to carry the second
mortgage at rates lower than traditional lenders.
But, Rob is right. There are some disadvantages that often get overlooked.
Second mortgage rates are typically higher than those charged on first
mortgages. It's possible that the combined mortgage payments could be
higher than a single mortgage plus PMI payment.
The second mortgage will have a second set of costs associated with it.
Some even carry a prepayment penalty.
And, second mortgage payments will continue until that loan is paid off.
PMI can be cancelled when your equity reaches 20%.
Rob also should beware of 'balloon payments' on the second mortgage. He may
be offered a loan that's amortized over 30 years. In other words, the
payments are calculated as if you'll be making them for 30 years. That
makes for low monthly payments. But at some point in the future (usually
10, 15 or 20 years) the balance of the loan is due. That balance is the
'balloon'. And the homeowner is required to come up with the cash or
refinance at that point.
So which is best? In part it will depend on the rates that Rob will be
offered on first, second and PMI. He'll also need to consider how long it
will be before he has a 20% equity in the home and can cancel PMI. Rob can
take that info and estimate what his payments will be in future years.
Unfortunately predicting the future isn't an exact science. So there is no
one correct answer.
Finally, a warning to Rob and others with small down payments. Housing
prices can decline. One industry study estimates that there's roughly a 6%
chance that housing prices could drop 10% in the next two years.
When interest rates rise people will not able to afford as much housing.
For instance, if rates rise from 6% to 7%, a buyer can only spend 90% of
what he could at the lower rate. So the check that paid for a $200,000
mortgage now becomes the payment for a $180,000 loan. That could hold down
Many people are familiar with the concept of being 'upside down' in a car
loan. That's where they owe more money than the car is worth making it
difficult to sell or trade the car.
Being upside down in a mortgage could be significantly more painful.
Imagine that you've lost your job and need to move to a new city to regain
employment. But the only way that you can sell your home is to bring a
check for $10,000 to the closing because you owe more than it's worth. For
many that would be an impossibility. So please move cautiously if you're
buying with a minimal down payment.
Gary Foreman is a former financial planner who currently edits The Dollar
Stretcher website <www.TheDollarStretcher.com>
If you'd like to 'live better...for less' visit today. You'll find thousands of
articles to help stretch your day and your dollar.