Mortgage lenders hunting for originations have taken notice of the homebuyer plight to save for a 20% down payment, and they’ve got a fast-patch solution to bump up lending: second mortgages.
Second mortgages, sometimes referred to as piggyback mortgages when paired with a purchase-assist first mortgage, allow a homebuyer to finance a greater percentage of the purchase price on a home — without the cost of mortgage insurance.
For example, a homebuyer putting less than 20% down and acquiring a conventional mortgage with a loan-to-value ratio (LTV) above 80% is required to have private mortgage insurance (PMI) to cover the lender’s increased risk of loss. When the mortgage is insured by the Federal Housing Administration (FHA), the homebuyer needs to pay a mortgage insurance premium (MIP) to compensate for risk of loss inherent in financing an acquisition with a minimal down payment — as low as 3.5%. However, when the purchase-assist financing is bifurcated between a first and a second mortgage, the homebuyer eliminates the need for PMI on the first mortgage of 80% LTV or less.
Lenders, credit unions and jumbo mortgage lenders have started originating first mortgages with low down payment thresholds when coupled with funding from a second mortgage. For example, Bank of America (BofA), in partnership with Self-Help and Freddie Mac, launched their Affordable Lending Mortgage Program in February 2016. However, these second mortgages don’t always reduce costs in the way homeowners think.
Instead of charging a monthly PMI, mortgage lenders may defer the debt payment burden of the second mortgage (or “sleeping second”) until:
- the first mortgage is paid off;
- the homeowner refinances the first mortgage; or
- the homeowner sells the mortgaged property.
On the occurrence of one of these events, the homeowner has to pay the total principal balance on the second mortgage — and the interest accrued and unpaid on the second mortgage.
The second mortgage permits a higher standard of living today by deferring payment of 1/6th of the purchase price with interest for 30 years. However, the simple act of taking out two mortgages to finance the home purchase automatically makes the buyer a higher default risk for the dual lender than a buyer taking out one mortgage with a 20% down payment. Because the buyer using a second mortgage will have no skin in the game in the form of a sizeable down payment, lenders need to cover losses they will incur due to the increased risk of default.
Thus, buyers using second mortgages to finance their home purchase need to be aware the 80% LTV first mortgage will have a rate that is anywhere from .25% – .5% higher to fund a reserve to cover the lender’s no-down-payment risk — a built-in risk protection for the lender in lieu of the separate PMI coverage.
Thoughtful buyers will consider whether a single mortgage with PMI or a piggyback mortgage arrangement with a higher combined rate is within their comfort zone for future financial obligations of monthly and lump-sum due-date payments. Transaction agents best assist buyers through this process by encouraging them to shop various lenders, or seek the assistance of an mortgage loan originator (MLO)-endorsed broker to shop lenders, for different mortgage options which will fund the closing. [See RPI Form 312]
Second mortgages and overreaching homebuyers
The mention of second mortgages initially alarms real estate professionals due to the vast amount of homebuyers who used them to overreach their financial capabilities during the Millennium Boom. Other second mortgages on homes take the form of home equity lines of credit (HELOCs). As home equities rose dramatically in the 2000s, homeowners eager to turn their home equity into expendable cash took out HELOCs, essentially converting their home equity into an ATM for instant cash as needed (for fancy toys, mostly). Enter the market collapse and financial crisis, and second mortgage lenders retreated with their coattails badly singed.
However, the recent revival of second mortgages is unlikely to wreak the same havoc that resulted from the overly ambitious lending of the Millennium Boom — hindsight is 20/20, and the memory is not pretty. Then, homeowners used second mortgages to fund the purchase of depreciating assets like new vehicles and other expensive indulgences under the false impression of accumulated wealth – keeping up with the Joneses and looking good.
Although second mortgages have not changed in structure — or potential for abuse — today’s homebuyers are unlikely to take amnesiac joyrides on extra mortgage funds. The effects of the Great Recession are still felt in homebuyers’ parched wallets and savings accounts, regardless of lenders’ lack of precaution in divvying out second mortgages. Lenders may return more easily to second mortgages, eager to pad their bottom line, but cautious homeowners have yet to forget the devastating effects of overreaching financially during the crisis.
Instead, homebuyers now are taking on the piggyback debt to avoid the nearly 1% additional annual cost of PMI premiums and compensate for underwhelming down payments. Student loan debts, immobile wages and high rents combine to prevent potential homebuyers from accumulating the historic 20% down payment and encourage roundabout methods of balancing homeownership costs.
Monthly mortgage insurance payments, accounting for nearly 1% of the principal balance annually, only complicate matters for homebuyers. A key limitation set by federal home mortgage law sets the debt-to-income ratio (DTI) including mortgage payments at 43% for a qualified mortgage – which is what the big banks are into.
About 65% of homebuyers nationally put down less than 20% in 2015 (excluding jumbo mortgages), according to Inside Mortgage Finance. Additionally, increasing trends in nonbank issuance of minimal qualification mortgages signal homebuyers’ pursuit of purchase-assist financing through lower down payments.
What’s the verdict for California homebuyers?
The personal savings of California residents have remained low since the housing crash, reaching only 5.2% in Q4 of 2015. However, second mortgages aren’t the only way to manage purchase-assist financing — especially for first-time homebuyers. Mortgage assistance programs and consumer mortgage shopping tools help guide homebuyers through the process of finding a lender with the best rates and payment schedules for their income level. Future homebuyers may also reap the benefits of a currently pending bill allowing the deduction of homeownership savings account expenses, including down payments, from taxable income.
Real estate agents are the gatekeepers entrusted to ensure their buyers are aware of the costs and risks of different mortgage types – lenders will not and have no duty to do so. Dedicated transaction agents review the pros and cons of low down payments and government-backed mortgages with their buyers, as well as the risks of second mortgages. The agent accomplishes this during their buyer’s pre-approval process before beginning the search for a suitable home.
A simple mortgage comparison worksheet can help buyers find a satisfying mortgage rate, obtain their dream home and encourage them to refer fellow buyers back to agents who give reliable financial advice. [See RPI Form 312]