Mortgage Piggybacks in a Stressed Market
February 18, 2008, Revised June 19, 2008, Reviewed July 24, 2009
One consequence of the rise in mortgage foreclosures is that piggyback second mortgages, used by borrowers who can't put 20% down, have become more costly than mortgage insurance. Further, borrowers having payment troubles looking to get the terms of their first mortgage modified, are finding that a second mortgage complicates the process.
A piggyback is a second mortgage taken out at the same time as a first mortgage, as a way of borrowing a larger total amount. The first mortgage is for 80% of property value, and therefore does not require mortgage insurance, while the piggyback is for 5%, 10%, 15% or 20% of value. Instead of a mortgage insurance premium, the borrower pays a higher rate on the piggyback than on the first mortgage. See Piggyback Loans: Two Mortgages Cost Less Than One?
Whether a piggyback saves the borrower money relative to mortgage insurance depends on many factors, including the rate on the piggyback relative to that on the first mortgage. These factors are pulled together in calculator 13a, Mortgage Piggyback Calculator: Two Mortgages Versus One Larger Mortgage.
During the years 2000-2006, the advantage seemed to favor piggybacks, and they grew rapidly at the expense of mortgage insurance. It helped that interest on piggybacks was tax deductible and mortgage insurance premiums were not. In addition, because of the marked appreciation in home prices during this period, piggybacks were under-priced.
Because a piggyback lender, in event of a foreclosure, only recovers what is left after the first mortgage lender is paid off, the risk of loss on a piggyback is critically dependent on what happens to home prices. With prices rising 7% or more a year as they did during 2000-20006, even a 20% piggyback acquires a comfortable equity cushion after a few years. It appears that piggyback lenders, sharing the euphoria that pervaded the entire market, priced on the assumption that prices would continue to rise. I have called this "disaster myopia", see Upheaval in the Sub-Prime Mortgage Market.
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 seconds, and it doesn’t pay the lender to foreclose. In some cases, lenders are writing the loans off, 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 mortgage are regretting that they had earlier selected a piggyback over mortgage insurance. If the two mortgages are held by different lenders, as is frequently the case, the first mortgage lender who might otherwise be inclined to modify the contract so the borrower can afford it, won’t do it 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 place to go – except to foreclosure.
If a borrower in trouble had earlier refinanced the piggyback to get cash, he might lose protection against a deficiency judgment in states like California that restrict them. [Deficiency judgments allow lenders to pursue borrowers for any amounts due them that have not been paid with proceeds of property sales.] Protection against deficiency judgments only applies to loans used to acquire homes.
In the currently stressed loan market, the prices of piggybacks are substantially higher than they were, 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 soon you will come into a pot of 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 the piggyback, just by paying it off. In contrast, getting rid of mortgage insurance by paying down the balance takes a minimum of 2 years and in many cases much longer.
This has become important because it now takes longer to sell a house than it did, and many house purchasers with old 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 very handy to have in that situation.
One consequence of the rise in mortgage foreclosures is that piggyback second mortgages, used by borrowers who can't put 20% down, have become more costly than mortgage insurance. Further, borrowers having payment troubles looking to get the terms of their first mortgage modified, are finding that a second mortgage complicates the process.
Role of the Piggyback
A piggyback is a second mortgage taken out at the same time as a first mortgage, as a way of borrowing a larger total amount. The first mortgage is for 80% of property value, and therefore does not require mortgage insurance, while the piggyback is for 5%, 10%, 15% or 20% of value. Instead of a mortgage insurance premium, the borrower pays a higher rate on the piggyback than on the first mortgage. See Piggyback Loans: Two Mortgages Cost Less Than One?
Whether a piggyback saves the borrower money relative to mortgage insurance depends on many factors, including the rate on the piggyback relative to that on the first mortgage. These factors are pulled together in calculator 13a, Mortgage Piggyback Calculator: Two Mortgages Versus One Larger Mortgage.
Growing Use of Piggybacks During 2000-2006
During the years 2000-2006, the advantage seemed to favor piggybacks, and they grew rapidly at the expense of mortgage insurance. It helped that interest on piggybacks was tax deductible and mortgage insurance premiums were not. In addition, because of the marked appreciation in home prices during this period, piggybacks were under-priced.
Because a piggyback lender, in event of a foreclosure, only recovers what is left after the first mortgage lender is paid off, the risk of loss on a piggyback is critically dependent on what happens to home prices. With prices rising 7% or more a year as they did during 2000-20006, even a 20% piggyback acquires a comfortable equity cushion after a few years. It appears that piggyback lenders, sharing the euphoria that pervaded the entire market, priced on the assumption that prices would continue to rise. I have called this "disaster myopia", see Upheaval in the Sub-Prime Mortgage Market.
Piggybacks Severely Impacted by the Mortgage Crisis
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 seconds, and it doesn’t pay the lender to foreclose. In some cases, lenders are writing the loans off, 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 mortgage are regretting that they had earlier selected a piggyback over mortgage insurance. If the two mortgages are held by different lenders, as is frequently the case, the first mortgage lender who might otherwise be inclined to modify the contract so the borrower can afford it, won’t do it 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 place to go – except to foreclosure.
If a borrower in trouble had earlier refinanced the piggyback to get cash, he might lose protection against a deficiency judgment in states like California that restrict them. [Deficiency judgments allow lenders to pursue borrowers for any amounts due them that have not been paid with proceeds of property sales.] Protection against deficiency judgments only applies to loans used to acquire homes.
In the currently stressed loan market, the prices of piggybacks are substantially higher than they were, 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.
An Unforeseen Advantage of 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 soon you will come into a pot of 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 the piggyback, just by paying it off. In contrast, getting rid of mortgage insurance by paying down the balance takes a minimum of 2 years and in many cases much longer.
This has become important because it now takes longer to sell a house than it did, and many house purchasers with old 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 very handy to have in that situation.