By Jack Guttentag
Saturday, March 15, 2008
A piggyback loan is a second mortgage taken out at the same time as a first mortgage as a way of borrowing a larger total amount without having to pay mortgage insurance. The first mortgage is for 80 percent of property value and therefore does not require insurance. Then the piggyback loan is for 5 to 20 percent of the value. Instead of a mortgage insurance premium, the borrower pays a higher rate on the piggyback than on the first mortgage.
Whether a piggyback saves the borrower money relative to mortgage insurance depends on many factors, including the rate on the piggyback vs. that on the first mortgage. (Calculator 13a on my Web site, http://www.mtgprofessor.com, helps compare these expenses.)
From 2000 to 2006, the numbers seemed to favor piggybacks, and they grew rapidly at the expense of mortgage insurance. Interest on piggybacks was tax-deductible, and mortgage insurance premiums were not. In addition, because of the appreciation in home prices during this period, piggybacks were underpriced.
In a foreclosure, a piggyback lender recovers only what is left after the first mortgage lender is paid off, making the risk of loss on a piggyback critically dependent on what happens to home prices. With prices rising 7 percent or more a year, as they did from 2000 to 2006, it doesn't take long to build a comfortable equity cushion. It appears that piggyback lenders, sharing the euphoria that pervaded the entire market, set rates on the assumption that prices would continue to rise. I have called this "disaster myopia."
When the disaster struck in 2007, the default rate on piggybacks soared and investors in second mortgages began paying a stiff price for their mistake. With home prices declining, there is no equity protecting many of these second loans, and it doesn't pay for the lender to foreclose. In some cases, lenders are writing off the loans, though the borrower remains liable and cannot sell the house without a sign-off from the lender.
Many of the borrowers who are having payment problems with their first mortgages are regretting that they selected a piggyback over mortgage insurance. If the two mortgages are held by different lenders, as is frequently the case, the first mortgage lender, which might otherwise be inclined to modify the contract so the borrower can afford it, won't do so unless the second mortgage lender also makes a concession. This so complicates the process that it may not get done, leaving the borrower with no option except foreclosure.
In the current loan market, the prices of piggybacks are substantially higher than they had been, and this has shifted the balance back toward mortgage insurance. A year ago, the sum of the payments on two mortgages in most cases was below the sum of one payment plus a mortgage insurance premium. Today, reflecting the higher rates on piggybacks, in most cases the opposite is true. Further, Congress has made mortgage insurance premiums deductible for some borrowers, at least for some years, largely neutralizing one of the arguments for the piggyback.
However, the stressed market has also revealed an advantage of the piggyback over mortgage insurance that was not very important before: If you borrow with a small down payment but anticipate that you will soon come into money that you will use to pay down the balance, it is better to have a piggyback than mortgage insurance. You can get rid of a piggyback and the interest payment on it just by paying it off. In contrast, getting rid of mortgage insurance by paying down the balance takes a minimum of two years and can be much longer.
This has become important because it now takes longer to sell a house, and many home buyers with homes to sell are not waiting. Without the equity from their old home, they make small down payments, anticipating that as soon as the old home sells, they will pay down the balance of the new loan. Piggybacks are handy in that situation.
Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.
Copyright 2008 Jack Guttentag
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