Piggyback Loan

A piggyback loan is a second mortgage taken out at or before the closing of a home purchase, secured by the same property and made to the same buyer, so that the first mortgage can be written for a smaller share of the price. The usual purpose is to keep the first lien at 80 percent of value or less, because that is the threshold at which conventional lenders stop requiring private mortgage insurance, and sometimes also to keep the first lien under the conforming loan limit and out of jumbo pricing.

Consumers and lenders say "piggyback"; the regulation says something else, and the difference is worth keeping straight. Regulation Z defines a simultaneous loan at 12 CFR 1026.43(b)(12) as "another covered transaction or home equity line of credit subject to § 1026.40 that will be secured by the same dwelling and made to the same consumer at or before consummation of the covered transaction or, if to be made after consummation, will cover closing costs of the first covered transaction." That definition is broader than a piggyback: it reaches a home equity line and it reaches a loan made after closing to cover the first loan's costs. So a piggyback is a species of simultaneous loan rather than another word for one. In the disclosure rules the phrase is "simultaneous subordinate financing." The official commentary to Regulation Z uses the consumer word, in quotation marks, when it gives an example: a creditor "must consider the consumer's periodic payment obligation for any 'piggyback' second-lien loan that the creditor knows or has reason to know will be used to finance part of the consumer's down payment."

The shapes, and what each digit means. In 80/10/10, the first mortgage is 80 percent of the purchase price, the second lien is 10 percent, and the buyer puts 10 percent down. In 80/15/5 the second lien is 15 percent and the deposit is 5. The first number is the one doing the work, because 80 percent is where two separate thresholds sit: the point at which a conventional first mortgage stops requiring private mortgage insurance, and a common ceiling in lenders' own pricing grids. Either loan can be a fixed-rate second mortgage or a home equity line of credit, and which one it is changes the analysis considerably, because a line of credit typically carries a variable rate.

The comparison that decides it is not the one usually advertised. A piggyback is marketed as a way to avoid mortgage insurance, and it does avoid it. Whether that is an improvement depends on four things, and only the first gets discussed. The first is the rate on the second lien, which is usually well above the first mortgage rate because the lien sits behind it. The second is whether that rate is fixed, because a variable-rate line of credit transfers rate risk to the borrower for as long as the balance is outstanding. The third is that private mortgage insurance ends and a second mortgage does not: the Homeowners Protection Act gives a borrower a right to request cancellation, and requires automatic termination, once stated equity thresholds are reached, on the ladder the mortgage insurance page sets out, while a second lien ends only when it is paid off. The fourth is the interest deduction, which is worth checking rather than assuming, because acquisition indebtedness under Internal Revenue Code section 163(h)(3) can include debt incurred in acquiring the residence whether it sits in first or second position, subject to the overall limit.

The regulatory hook, and why it exists. Under 12 CFR 1026.43(c)(2)(iv), a creditor making a covered transaction must consider "the consumer's monthly payment on any simultaneous loan that the creditor knows or has reason to know will be made," calculated under (c)(6). The official commentary explains what that obliges a lender to do in practice: where the requested loan amount is less than the purchase price, the creditor's policies and procedures must require the consumer to state the source of the down payment and provide verification, and if the source turns out to be another extension of credit secured by the same dwelling, the payment on it has to be counted. This is a direct response to what happened before 2008, when piggyback seconds were routinely arranged outside the first-lien lender's view and the combined payment was never underwritten.

The conforming-limit use is a different motive with the same structure. On an expensive property, splitting the financing can keep the first mortgage at or under the baseline conforming loan limit, which for a one-unit property in most of the country is $832,750, and therefore inside conventional pricing rather than in the jumbo market. Whether that is worth doing turns on the spread between conforming and jumbo pricing at the time, which moves, and on the rate the second lien carries.

The sleeper cost is the refinance. A second lienholder does not automatically step aside when the first mortgage is replaced. To refinance the first, the borrower needs the second lienholder to sign a subordination agreement, and it is not obliged to. If it refuses, or takes months, or charges for it, the refinance either does not happen or has to pay off the second lien as well, which converts the transaction into a cash-out refinance at cash-out pricing. Borrowers who chose a piggyback in a high-rate year and want to refinance in a low-rate one meet this problem at exactly the wrong moment.

Where the second lien stands if things go wrong. A junior lienholder is paid only after the first is satisfied, which shapes what happens in a short sale or a foreclosure and is covered on the pages for those transactions and for home equity loans. The short version is that a second lien gives its holder a veto in a short sale, which is one of the main reasons those transactions fail.

Both loans are underwritten and closed together. The first-lien lender is required to know about the second and to count its payment; the second-lien lender knows it is behind the first and prices accordingly. At closing, the first mortgage, the second mortgage and the buyer's cash together fund the purchase.

A hypothetical comparison. Suppose a home costs $600,000 and the buyer has $60,000, which is 10 percent.

Under the piggyback route, the first mortgage is $480,000, exactly 80 percent of $600,000, and the second lien is $60,000. Combined, the two liens are $540,000, which is 90 percent of the price. At a hypothetical 9 percent on the second lien, the interest alone in the first year is $60,000 multiplied by 0.09, or $5,400, which is $450 a month.

Under the mortgage insurance route, there is one loan of $540,000, again 90 percent of the price. At a hypothetical annual premium rate of 0.5 percent of the loan balance, the premium is $540,000 multiplied by 0.005, or $2,700 a year, which is $225 a month.

On these hypothetical numbers the piggyback costs about twice as much per month in the early years, and the usual pitch has it backwards. What the comparison leaves out cuts both ways. In the piggyback's favor: part of each second-lien payment reduces principal, whereas the insurance premium buys the borrower nothing, and the second-lien interest may be deductible where the premium's treatment is a separate question. Against it: the insurance stops by operation of law once the statutory equity threshold is reached, and the second mortgage stops only when it is paid. Change the second-lien rate to 6 percent and the piggyback's annual interest falls to $3,600, and the answer changes with it, which is the point. The structure is not cheaper or dearer as a category; it is cheaper or dearer at a given pair of prices, and the arithmetic has to be run on the actual quotes.

Pros

• Avoids private mortgage insurance on a purchase with less than 20 percent down, without waiting to save the full deposit.
• Part of every second-lien payment reduces principal, which a mortgage insurance premium never does.
• Can keep the first mortgage under the conforming loan limit on an expensive property, which may mean conventional rather than jumbo pricing.
• Interest on debt incurred to acquire the residence can qualify as acquisition indebtedness whether it sits in first or second position, subject to the overall limit.

Cons

• The second lien is usually priced well above the first, and if it is a line of credit the rate is typically variable.
• It does not end on its own. Mortgage insurance has a statutory cancellation and termination schedule; a second mortgage has to be paid off.
• Refinancing the first mortgage requires the second lienholder to subordinate, and it is under no obligation to agree.
• Two loans means two sets of terms, two payment streams, and a second lienholder with a veto in any short sale.
• The combined payment is what has to be affordable, and the higher second-lien rate can make total monthly cost higher than the insured single-loan route.