Piggyback Financing and Interest Only Mortgages
Mortgage Commentary

Popular home finance options carry risks

By Dian Hymer

February 28, 2005

Home prices increased significantly over the last few years. During this time, two financing options -- piggyback financing and interest-only mortgages -- increased in popularity because they can make it easier for buyers to qualify to buy a more expensive home.

Mortgage rates are expected to move up this year. As they increase, more buyers could turn to these mortgage alternatives. It's important to understand that with easier loan qualification comes increased risk.

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With piggyback financing, the borrower combines a first mortgage with a second mortgage. This is done in lieu of borrowing one mortgage for the entire amount you need. Often, first-time buyers with low cash down payments use piggyback financing to avoid paying mortgage insurance.

Mortgage insurance (MI, also called PMI) is often charged on mortgages for 90 percent or more of the purchase price. MI adds to the cost of home ownership, and currently it is not tax-deductible. By combining a first mortgage for less than 90 percent of the purchase price with a second mortgage for the balance, a borrower can avoid MI.

Repeat home buyers often use piggyback financing as interim financing. In this case, the second mortgage is usually paid off quickly, as soon as their old home sells. But for first-time buyers, the second mortgage can be a long-term proposition.

With this in mind, it's wise to look beyond the immediate cost savings of piggyback financing when evaluating your financing options. For example, the interest rate charged on a second mortgage is usually significantly more than the rate charged on a first mortgage. From the lender's standpoint, secondary financing is riskier. For higher risk, investors require a higher return.

Most 30-year, fixed-rate mortgages are paid off over 30 years. These payments are amortized so that part of each monthly payment goes to pay the interest owed and part goes toward paying back the principal (the amount borrowed). At the end of 30 years, the borrower owes nothing.

Fixed-rate second mortgages are usually due in 15 years. A shorter amortization period requires a higher monthly payment. To make qualifying easier, these loans are usually amortized over 30 rather than 15 years. This lowers the monthly payment amount, but since the payments don't completely pay off the loan, a balloon payment is due at the end of 15 years.

Most buyers, who opt for a mortgage with a balloon payment, assume that they will either sell or refinance before the loan comes due. However, if interest rates are much higher when you want to refinance, you could have difficulty qualifying unless your income has increased substantially.

Some buyers borrow adjustable rate second mortgages, which carry lower initial interest rates. Unlike fixed-rate mortgages, the interest rate on adjustable rate mortgages is affected by changes in the Federal Reserve Discount Rate. This rate increased 5 times in 2004. The Federal Reserve is expected to continue increasing rates this year. Borrowers with an adjustable rate second, could see their borrowing costs increase this year.

Interest-only mortgages are popular with buyers who are trying to keep their mortgage costs as low as possible. Your monthly payments on an interest-only loan pay the interest owed, but do not pay back principal, unless you make additional principal payments.

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You enjoy lower monthly payments with an interest-only mortgage, but only for a time. At some point you either have to pay the loan off with a balloon payment, or the principal is amortized over the remaining loan term. At this point, your monthly payments could jump dramatically.

THE CLOSING: Piggyback financing and interest-only mortgages are the right choice for many home buyers. But, there are risks involved. Before you decide on any mortgage product, it's wise to consider the pros and cons.

Dian Hymer is author of "House Hunting, The Take-Along Workbook for Home Buyers" and "Starting Out, The Complete Home Buyer's Guide," Chronicle Books.