Here piggy, piggy!

In mortgage industry parlance a piggyback transaction is when you get both a first Trust Deed (TD) or mortgage loan and a second loan at the same time to finance the purchase of a home. We do a lot of these because it is a mechanism whereby you can avoid paying Private Mortgage Insurance (PMI) on loans where you put down less than 20 percent.

This strategy can be used in several ways. Most first-time home buyers have only 5 percent or 10 percent down, sometimes nothing at all. Thus you may hear these piggyback transactions referred to as an 80-10-10, where someone is putting down 10 percent, or 80-15-5 when they are only putting down 5 percent.

While there are programs that will provide funding for these transactions with only one loan, they are expensive. With many lenders, the upfront additional charge for doing 100 percent financing is 1.5 points, or, in other words, 1.5 percent. If you are going to pay 1.5 points, why not get another 3.5 percent and use it as a down payment? Note that many lenders also have an "add-on" for an 80-15-5, which is more like 1/4 of 1 percent -- easier to swallow.

Because they are so much cheaper, most of these transactions are done with a Home Equity Line of Credit (HELOC). These are variable-rate loans, usually tied to the prime rate, but even with a small margin over prime it still has an effective rate in the 5 percent range. Obviously if you have a fixed-rate first loan, there is some risk here because when the prime rate goes up, so will the cost of this mortgage. But note that the dollar amount of the HELOC is so much lower that the actual payment increase would not be onerous.

You could get a fixed-rate second, but the rates on these are usually in the 7 percent range. I don't know where prime rate is headed, but it seems that getting a 7-plus-percent loan is like signing up for the worst-case scenario.

When I work through possible scenarios with my clients I have yet to have someone say, "That sounds too risky for me!" They all have opted for this kind of transaction. Indeed, I have run calculations on many possible scenarios and in every instance the piggyback transaction is cheaper over the first few years. Those savings, in my view, more than compensate for the potential risk, and my clients have agreed.

We have unwound many of these transactions a few years later, after the purchase, when the property values have gone up. When the loan balance is less than 80 percent of the home's current value, we can get one new loan and pay off both of the old ones. Rates have been down, too, so we can improve the rate on the first loan. It almost never makes sense to refinance if the interest rate on the first can't be improved. The costs of a refinance are just too great.

If you are getting one of these now, when rates are so low, your opportunity to refinance a couple of years from now may not be there. Obviously, if your home is going to be a long-term investment, you would want to devote your energy to paying off the HELOC loan.  

You can even make a case for getting an interest-only first loan, then take what you would have been paying in principal reduction on the first and apply it all to the second. Of course, when the second is paid off, you will want to switch and make the same total payment on the first as you were before on both loans.

Finally, there is a new wrinkle in piggybacks. Someone who wants to make no down payment can get an 80-20 loan. The downside is that the lender will only fund 15 percent of the loan, not the full amount, so you have to come up with the 5 percent down payment. Most lenders will allow gifts of that 5 percent, which we all know really aren't gifts but loans. A few days after close, the other 5 percent is available to you and you can draw on it and pay back the "gift."