Low down payment? A piggyback loan or PMI can help Hawaii

You’re ready to buy a home and you’ve decided to make a down payment that’s less than 20 percent of the purchase price. That decision triggers yet another one: Should you obtain a piggyback loan to create a 20-percent down payment or should you instead pay for mortgage insurance?

What is a piggyback loan?

"Piggyback" is an evocative description of a second loan for additional money that seemingly rides on the back of your first mortgage. Common piggybacks include traditional second mortgages, home equity loans and home equity lines of credit. Piggybacks can meet a variety of needs, one of which is the avoidance of mortgage insurance.

What is mortgage insurance?

Mortgage insurance is a financial product that protects your lender from the risk that you might not pay back the money you borrowed to purchase your home. Lenders typically require this insurance, which protects the lender from loss, if your down payment is less than 20 percent of the purchase price of your home. The smaller down payment means you have less equity at risk and thus, in the lender’s analysis, might be more likely to default on your mortgage.

Mortgage insurance can be purchased through government agencies or private-sector companies. The insurance is paid for monthly, usually as part of your mortgage payment.

In theory, mortgage insurance can be cancelled if the equity in your home grows to 20 percent of the home’s appraised value. In practice, however, lenders are loath to forgo the financial protection at your expense. You can ask your lender to cancel the insurance when your equity is more than 20 percent of the home’s value.

How a piggyback avoids PMI

A piggyback loan can eliminate the mortgage insurance requirement because the additional money from the second loan increases your down payment to 20 percent.

Suppose you purchased a $250,000 home and made a down payment of $25,000, or 10 percent. If you obtained a first mortgage of $225,000, the lender typically would require mortgage insurance. But if you obtained a first mortgage of $200,000 and a piggyback loan of $25,000, the separate $25,000 piece would increase your down payment to 20 percent and mortgage insurance wouldn’t be required. The catch is that the piggyback would be a second mortgage, and as such, it would have a higher interest rate than your first mortgage.

Pros and cons of piggyback approach

The key question when choosing between a piggyback loan or mortgage insurance is whether the higher rate of interest and additional loan origination costs for the piggyback would be more or less costly than the mortgage insurance.

The piggyback oftentimes may be the clear winner. But not always. If you intend to own your home only a few years, the mortgage insurance might be less expensive than the piggyback. Consider also that the piggyback could be paid off while mortgage insurance could be difficult to eliminate.

Your lender or mortgage broker should be able to explain the costs and tradeoffs to you, and some Web sites have calculators that can help you make the comparison between a piggyback and mortgage insurance. Research your options to figure out which choice is appropriate for your individual situation.