Thursday, February 07, 2008

Multi-Layered Loans Lower Down Payment, PMI

by M. Anthony Carr

If you're in the market to buy a home but have little down and want to avoid private mortgage insurance, you might want to look at the multi-layered financing options which have become increasingly available.

With these programs, there's a first loan equal to 80 percent of the purchase price, and a second loan for 10 or 15 percent of the remaining costs. The remaining money, 10 percent or 5 percent, is the buyer's down payment.

Described as "80/10/10" and "80/15/5" financing, buying with multiple loans allows purchasers to avoid the up-front costs and monthly expenses associated with private mortgage insurance (PMI).

Private mortgage insurance is a policy taken out by borrowers who lack big downpayments. Statistics show that buyers who purchase with less than 20 percent down have a higher risk of default than those who purchase with a downpayment of 20 percent or more.
If you buy with less than 20 percent down, lenders will generally require that you purchase with PMI when financing with a conventional loan. In the event of default, the policy kicks in to protect the lender.

(It's also possible to buy without PMI. In these cases, the lender self-insures -- you don't pay PMI, but you do pay a somewhat higher interest rate.)

Insurance coverage requirements for government programs such as VA and FHA loans are somewhat different.

With FHA, there is a "mortgage insurance premium" or MIP. FHA loans have a 1.5 percent up-front fee plus a monthly premium equal to .5 percent of the outstanding loan balance. FHA programs generally allow homes to be purchased with 3 percent down. The up-front fee can be financed as an addition to the loan amount.

First-time VA borrowers do not pay a monthly premium, however they do face an up-front "funding fee" equal to 2 percent of the loan amount in most cases. Many VA loans are for more than 100 percent of the value of the house, since Uncle Sam allows military veterans to finance closing costs.

Multi-layered loans are for people who want to buy with conventional financing, don't have 20 percent down, don't want to pay PMI, and don't want to wait for years to acquire a massive downpayment. In such cases they obtain a first mortgage equal to 80 percent of the purchase price. There is no PMI requirement here because there is a 20 percent gap between the amount borrowed and the purchase price.

The borrowers then obtain a second loan equal to 10 to 15 percent of the purchase price. Combine the 80 percent first loan with financing equal to another 10 to 15 percent of the purchase price, and the borrower must now bring 5 to 10 percent of the purchase price to closing as a downpayment. If you're looking at purchasing a house with a second trust, there are a couple of nuances about a second mortgage of which you should be aware.

The interest rate for the second loan is going to seem a bit higher than what you will be quoted for a regular mortgage. For instance, if you're paying 7 percent on the first trust, don't be surprised if interest on the second mortgage is considerably higher. Shop and compare rates for both loans, and look at your total monthly costs.

The interest rate for the second loan is going to run higher because the loan has more risk to the lender. In case of a default, the first trust holder may foreclose to receive payment on the loan while the second mortgage holder doesn't get a cent until the first-trust holder is paid completely. In addition, the amount of the loan is so small that the lender/investor must charge a higher interest rate to receive ample compensation.

Second trusts typically last for 5 to 15 years. Because they have a short term, they require big monthly payments to be quickly re-paid -- or they have low monthly payments and at the end of the loan term the borrower faces a big single payoff, a so-called "balloon" payment. If you can't pay or refinance the balloon payment, the property can be foreclosed.

The mortgage insurance industry argues that multi-layed loans, so-called "piggyback" financing, may be less attractive than the combination of a bigger first loan plus PMI. (See this calculator here from to see if it makes sense for you.)

But whether you prefer multi-layered financing or a big loan plus PMI, the fact is that both options allow you to buy with little down, both have costs, and both have risks. Each option should be reviewed with care to see which works best for you.


RM_Apply said...

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