Home prices increased
significantly over the last few years. During this time, two financing options
-- piggyback financing and
interest-only
mortgages -- increased in popularity because they can make it easier for
buyers to qualify to buy a more expensive home.
Mortgage rates are expected to move up this
year. As they increase, more buyers could turn to these mortgage alternatives.
It's important to understand that with easier loan qualification comes
increased risk.
With piggyback financing, the borrower
combines a first mortgage with a second mortgage. This is done in lieu of
borrowing one mortgage for the entire amount you need. Often, first-time buyers
with low cash down payments use piggyback financing to avoid
paying mortgage insurance.
Mortgage insurance (MI, also called PMI) is
often charged on mortgages for 90 percent or more of the purchase price. MI
adds to the cost of home ownership, and currently it is not tax-deductible. By
combining a first mortgage for less than 90 percent of the purchase price with
a second mortgage for the balance, a borrower can avoid MI.
Repeat home buyers often use piggyback
financing as interim financing. In this case, the second mortgage is usually
paid off quickly, as soon as their old home sells. But for first-time buyers,
the second mortgage can be a
long-term proposition.
With this in mind, it's wise to look beyond
the immediate cost savings of piggyback financing when evaluating your
financing options. For example, the interest rate charged on a second mortgage
is usually significantly more than the rate charged on a first mortgage. From
the lender's standpoint, secondary financing is riskier. For higher risk,
investors require a higher return.
Most 30-year, fixed-rate mortgages are paid
off over 30 years. These payments are amortized so that part of each monthly
payment goes to pay the interest owed and part goes toward paying back the
principal (the amount borrowed). At the end of 30 years, the borrower owes
nothing.
Fixed-rate second mortgages are usually due
in 15 years. A shorter amortization period requires a higher monthly payment.
To make qualifying easier, these loans are usually amortized over 30 rather
than 15 years. This lowers the monthly payment amount, but since the payments
don't completely pay off the loan, a balloon payment is due at the end of 15
years.
Most buyers, who opt for a mortgage with a
balloon payment, assume that they will either sell or refinance before the loan
comes due. However, if interest rates are much higher when you want to
refinance, you could have difficulty qualifying unless your income has
increased substantially.
Some buyers borrow adjustable rate second
mortgages, which carry lower initial interest rates. Unlike fixed-rate
mortgages, the interest rate on adjustable rate mortgages is affected by
changes in the Federal Reserve Discount Rate. This rate increased 5 times in
2004. The Federal Reserve is expected to continue increasing rates this year.
Borrowers with an adjustable rate second, could see their borrowing costs
increase this year.
Interest-only mortgages are popular with
buyers who are trying to keep their mortgage costs as low as possible. Your
monthly payments on an interest-only loan pay the interest owed, but do not pay
back principal, unless you make additional principal payments.
You enjoy lower monthly payments with an
interest-only mortgage, but only for a time. At some point you either have to
pay the loan off with a balloon payment, or the principal is amortized over the
remaining loan term. At this point, your monthly payments could jump
dramatically.
THE CLOSING: Piggyback financing and
interest-only mortgages are the right choice for many home buyers. But, there
are risks involved. Before you decide on any mortgage product, it's wise to
consider the pros and cons.
Dian Hymer is author of "House Hunting,
The Take-Along Workbook for Home Buyers" and "Starting Out, The Complete Home
Buyer's Guide," Chronicle Books.
Copyright 2005 Dian Hymer
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