Piggyback Loans: Two Mortgages Cost Less Than One?

August 7, 2000, Revised November 29, 2006, December 3, 2007

Whether a piggyback second mortgage will cost a borrower less than mortgage insurance depends on a number of factors that are pulled together in my calculator 13a.

“I can’t afford to put 20% down. My broker says it will cost less to take out a combination first and second mortgage, where the second would provide another 10% down, than to put 10% down on a first mortgage and pay mortgage insurance premiums. He says that even though the rate on the second is high, I’ll come out ahead because the interest on the second is deductible. Mortgage insurance premiums are not. Is he right?”

He was right about the tax advantage of the combination loan before 2007, but Congress made mortgage insurance premiums paid in 2007 deductible if the loan was originated in that year. Whether this rule will be extended was unclear in late 2007. In any case, he is not necessarily right about coming out ahead with a piggyback, because that depends on many other factors.

Factors Affecting the Choice Between Second Mortgage and Mortgage Insurance

Interest rate on the second mortgage relative to the rate on the first: The smaller the difference in rate between the two mortgages, the greater the advantage of the combination relative to the single loan.

Term on the second mortgage relative to the term on the first: Shorter term loans pay down the balance faster than longer term loans. Since the second mortgage has a higher rate than the first, the faster the second is paid off relative to the first, the greater the advantage of the combination compared to the single loan.

Your tax bracket: Because the combination loan enjoys a larger tax write-off, the combination is most advantageous for borrowers in the highest tax bracket. This was not true in 2007, however, and may not apply in future years as well.

Closing costs: With one loan closing, closing costs should be the same for one loan or two. But if the second mortgage is from a different lender and requires a separate closing, the combination will have higher closing costs.

Expected appreciation rate: Borrowers can request that their mortgage insurance be terminated when the loan balance reaches 75% or 80% of the home’s appreciated value. This means that the higher the expected appreciation rate, the less the advantage of the combination.

Other factors: How long you expect to remain in the home and the rate of return you can earn on investments also affect how your choices shake out.

Pulling it All Together With a Calculator

Calculator 13a, Two Mortgages Versus One Larger Mortgage, pulls together all factors affecting the costs of both options on a fixed-rate mortgage. It also shows the “break-even rate” on the second mortgage, which is the highest rate it makes sense to pay. The combination will save you money if the market rate on the second is below the break-even rate.

Consider a borrower purchasing a $200,000 house who plans on remaining there for five years, and earns 5% on investments.

Example 1 assumes the borrower is in the highest income tax bracket (39.6%), expects only 1.25% appreciation on his home, and is shopping the market on July 29, 2000. He compares a 30-year first mortgage for $180,000 (10% down) at 8.25%, zero points, and mortgage insurance of .52%, with a combination of the same loan for $160,000 but no mortgage insurance plus a 15-year second mortgage for $20,000 at 11.75% and zero points. Closing costs are the same and mortgage insurance premiums are not deductible.

Over the 5 years, the breakeven rate for the second mortgage is 20.29% -- well above the market rate on a second. The combination is a clear winner.

Example 2 is the same except that the borrower is assumed to be in the 15% tax bracket. The breakeven rate on the second drops to 16.97%, but the combination remains the better deal.

Example 3 is the same as example 2 but the first mortgage has a 15 year term. The breakeven rate drops to 11.38%, slightly below the market rate on the second. The borrower is slightly better off with one mortgage.

Example 4 is the same as example 3, except that the borrower expects his house to appreciate at 5% a year, which makes possible early mortgage insurance termination. The breakeven rate drops to 10.10%, which is well below the market rate on the second. The borrower does significantly better with one mortgage.

Example 5 is the same as 4, except that the borrower must pay an additional $1,000 in closing costs on the combination loan. The breakeven rate drops to 8.68%, which makes the single mortgage more attractive yet.

In general, combination loans are least attractive to low tax bracket borrowers who take out short-term first mortgages, expect early termination of mortgage insurance, and face additional closing costs on combination loans.

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