How to Avoid PMI: The Return of Piggyback Loans

Private mortgage insurance (PMI) can add significantly to the cost of buying a home if you make a down payment of less than 20 percent. Under certain circumstances, you can use a piggyback loan to avoid paying for PMI. What is a piggyback loan, and how does it help you avoid PMI charges? Knowing the answer to that question could save you a considerable amount of money.

PMI and Piggyback Loans

PMI is a form of insurance lenders take out to protect themselves against borrowers defaulting on their loans. Of course, the main protection mortgage lenders have is the property as collateral, but when borrowers make relatively small down payments, home price fluctuations may mean that the value of the property does not fully cover the risk to the lender. Providing an additional form of protection when down payments are relatively small (typically less than 20 percent) is where PMI comes in.

A piggyback loan is a second mortgage used to augment the down payment on a home enough to allow the borrower to avoid PMI. For example, rather than making a 10 percent down payment and borrowing 90 percent of the purchase price in the form of a primary mortgage, you could add a 10 percent second mortgage to your down payment to bring the primary mortgage down to 80 percent of the value of the home. This should qualify you to avoid PMI charges.

However, there is more to this than simply avoiding the need for PMI. Whether or not the piggyback approach is worthwhile depends on the details of your individual situation.

5 Things You Should Know About Piggyback Loans

Is using a piggyback loan to avoid PMI a good fit for your situation? Knowing these five things will help you decide:

Expect to pay a higher interest rate on piggyback loans

Substituting a second mortgage for a portion of your primary mortgage in order to avoid PMI is not a cost-free proposition. There may be additional closing costs, and the interest rate on the second mortgage is almost certain to be higher than the rate on a comparable primary mortgage. This is because second mortgages are riskier to the lender, since the primary mortgage lender has first claim on the collateral in the event of default. So, the question becomes one of whether the additional cost of the piggyback loan is less than you would pay for PMI.

Don't base your decision purely on a comparison of initial monthly payments

In comparing the cost of the piggyback approach to borrowing the full amount from a primary mortgage with PMI, don't simply look at what the initial monthly payments would be. In most cases, you can discontinue PMI once your equity reaches 20 percent, so those charges would go away after a few years. Look at the total cost of each approach over the life of the loans.

As equity grows, look to retire your piggyback loan before your primary mortgage

If you do opt for the piggyback approach, try to pay the second mortgage back as quickly as possible, since secondary mortgage rates are generally higher than primary mortgage rates. You can accomplish this by opting for a shorter loan term up front (this should also help reduce the interest rate that you have to pay) or by making accelerated payments whenever you have extra money available.

Opportunities to refinance piggyback loans can be limited

Because of their added risk, the availability of second mortgages varies according to market conditions, so don't expect to be able to refinance a piggyback loan as readily as a primary mortgage.

Piggyback loans often require very strong credit

Since a second mortgage only gives the lender a subordinate claim on the collateral, lenders tend to be more careful who they will approve for these loans. The better your credit, the more likely you will be able to take advantage of the piggyback approach.

Because piggyback loans are riskier than primary mortgages, their availability may be limited and the rate premium charged will vary from lender to lender. This may mean you have to do some shopping around for the right lender, but it can be well worth the effort if you find one who can help you avoid paying for PMI.

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