If it’s time to send the kid off to college, build that mother-in-law suite you never thought you’d need or renovate the kitchen, you might need to leverage the equity in your home and explore a second mortgage, a home equity loan or a home equity line of credit (HELOC).
OK, first things first: the terminology of financing tied to a mortgage can be more than a little confusing, so let’s clear that up.
The term “second mortgage” often is used interchangeably to describe all types of equity-based secondary loans, while others use “home-equity loan” in that manner, and still others use either “second mortgage” or “home equity loan” to describe those paid out in a lump sum and “HELOC” for those that involve a line of credit. For the purposes of this guide, the term “second mortgage” will only be used to describe a second loan taken out at the same time as the primary mortgage, also called a “piggyback loan.” If it’s not a piggyback loan, then it’s either a home equity loan (lump-sum payout) or a home equity line of credit.
It’s important to understand the basics of each type of loan, review your financial picture and determine which product is the right option for you, so let’s take each in turn.
|Second (Piggyback) Mortgages|
|What are second mortgages and how they work|
|How to get a second mortgage|
|Second Mortgage Requirements|
|Home Equity Loans|
|What are home equity loans and how do they work|
|Home Equity Lines of Credit|
|What are home equity lines of credit and how do they work|
|How to Get a Home Equity Loan or Line of Credit|
|Home Equity Loan and HELOC Requirements|
What are piggyback mortgages and how do they work
A piggyback mortgage is a package of two loans with one loan added on top of the other. The borrower takes out a second mortgage at the same time the first mortgage is started or refinanced.
Piggyback mortgages are most commonly used to lower the loan-to-value ratio of the first mortgage to beneath 80 percent in order to eliminate the need for private mortgage insurance. Private mortgage insurance is usually required if a homeowner does not make at least a 20-percent down payment. They also appeal to borrowers who want to sidestep the higher interest rate of a jumbo mortgage.
The most common form of piggyback mortgages are “80-10-10” loans. The 80 represents the percentage of the property covered by the first mortgage. The first 10 represents the percentage of the property's value derived from the second loan and the final 10 percent comes from the borrower's down payment. Keep in mind, however, that the numbers aren’t necessarily fixed. Lenders often allow combinations of 80/15/5, 75/15/10, or any other combination provided you qualify.
While piggyback loans can be arranged as a fixed-rate loan or an adjustable-rate loan, it’s important to note that they feature shorter terms than first mortgages and carry a higher interest rate. If both the primary and the secondary mortgages are provided by the same lender, the 80/20 is usually treated as one combined mortgage, which means only one set of closing costs. If the primary and the secondary mortgages come from different lenders, you’ll face two sets of closing costs.
A piggyback mortgage might makes sense if you plan to keep your house for less than five years or you want to refinance in order to take cash out or fund home improvement.
To see how the different scenarios stack up, take two hypothetical scenarios:
- Loan A: a 90% loan with PMI and a 10% down payment
- Loan B: an 80% loan with a piggyback loan for another 10% and a 10% downpayment
- With Loan A, you have to pay the loan down to 80% before you can get rid of the PMI portion of the payment. The PMI portion of your payment does not reduce your principal balance.
- With Loan B, there is no PMI and every payment goes toward reducing your principal balance.
- So, if the PMI portion of the payment for Loan A is the same amount as the payment for Loan B, you will have your total outstanding mortgage balance down to 80% much faster.
In most cases, the amount you have to pay each month on the piggyback loan will be less than the amount you would have to pay in PMI. If you take the savings and make additional principal payments on your remaining mortgage, you can substantially reduce the repayment as well as the amount of interest you pay over the life of the loan.
Back to Table of Contents
If you’re interested in a piggyback loan, begin discussing the pros and cons with your mortgage lender. It will save you significantly on closing costs if you work with a single lender for both loans.
Once common, piggyback loans are now increasingly rare. The reason is simple: that second loan is immensely risky, and many lenders have backed away from the market in the wake of the recession. If a home is foreclosed on, the odds are overwhelming that the entire value of the second mortgage will be lost. Unlike a first loan, of course, there is no insurance to offset potential losses or the equity from a significant down payment to protect the lender.
So, if you are seeking a piggyback loan these days, your credit must be impeccable. You’ll want to get pre-approved for a primary mortgage to see if a piggyback loan is even possible. Pre-approval is an in-depth review process, in which a lender will request a variety of financial documents to review your credit score and other factors relating to your financial history. Based on this review process, the lender will tell you how much they are willing to lend you. It's not a commitment by the lender, but it does give you a good idea where you stand, and it will let you know if you’re eligible for a piggyback loan.
Back to Table of Contents
Homebuyers have fewer mortgage options to choose from these days. This is a direct result of the housing crisis that came to a head in 2008 but still ripples through the housing market. During the housing boom, piggyback loans were commonplace, but now they have all but disappeared in some regions. To qualify for a piggyback loan these days, you’ll likely need:
-- a FICO score of 640+
-- a debt-to-income ratio of 40% or less
-- stable employment for at least 2 years
-- a down payment of 5-10%
Back to Table of Contents
Home equity loans are more like conventional fixed-rate mortgages. Like a second mortgage, a home equity loan uses your home as collateral for a loan of a predetermined set amount. The lender pays out the full amount after approving the loan, and the recipient starts making payments immediately.
To calculate your home equity, take the current value of your home and subtract your mortgage amount. For example, if your home is worth $150,000 and you have a $100,000 mortgage, you have $50,000 of equity in your home. A home equity loan allows you to borrow money using your equity of $50,000 as security for, say, a $25,000 loan.
People who get fixed-rate home equity loans know that the interest rate and monthly payments stay the same for the life of the loan. Home equity loans usually carry higher interest rates than the initial rates on HELOCs. The interest paid on home equity loans is usually tax-deductible, but you should check with a tax consultant about possible exceptions. Some loans include a prepayment penalty clause, which imposes a fee when a homeowner pays off the debt prior to a specified time.
Back to Table of Contents
A home equity line of credit, or HELOC, is granted using the same percentage system as a home equity loan, but is issued in the form of a line of credit you can draw down in any amount up to the loan total that you need. Financial institutions determine the amount of your home equity loan or credit line by taking a percentage of the appraised value of the home and subtracting the balance of the mortgage. Most lenders cap home equity loans and HELOCS at 80% of the home’s appraised value. For example, if a home’s appraised value is $100,000, and the mortgage balance is $40,000, you’d be able to qualify for $40,000 in a HELOC.
Home equity lines of credit resemble credit cards in that no interest or payment is due until you actually spend money. Some lenders charge annual fees for having a HELOC account open, but most only assess accrued interest as you spend the money. Your monthly payment is based on the amount you have spent. As you pay down the balance, the line of credit is replenished.
You can withdraw any percentage of the HELOC balance at any time during the draw period, which typically is the first 10 to 15 years of the loan. During the second half of the note, called the repayment period, you can’t draw down the line any further if your loan is structured this way.
Home equity lines work well for people who plan on doing property improvements a few months down the line or for those planning for unexpected financial needs. Interest rates can fluctuate on equity lines, though, so there is no guarantee that the rate available the date a credit line opens will be the same when a person starts spending. Provided the HELOC is used for home improvement, any interest paid on a HELOC is is tax deductible. Interest is ordinarily tax-deductible up to $100,000, regardless of how it’s used. That makes HELOCs a good vehicle for those seeking to consolidate other debts.
Back to Table of Contents
1. Check Your Equity Level With an Appraisal
Make sure you have enough equity in your home to make the process worthwhile. Most lenders require a minimum of 20 percent equity in the home before they will approve a home equity loan. If you don’t have enough equity to secure a loan, then another loan product might serve you better.
Since your loan will be based on the current market value of your home, an appraisal is the first step in the process. Taking a few simple steps before you call the appraiser can help you maximize a second loan’s benefit. First, spruce up your home’s exterior, including your lawn, to boost curb appeal. Then tidy up the inside so that clutter doesn’t negatively influence the appraiser’s perception.
2. Find Your Lender
It pays to spend a bit of time broadening your search for a lender for home equity loans. Start with you current mortgage lender, where you already enjoy some leverage, but also contact other local lenders and do some online shopping as well. Use Wallet Hub to comparison shop, as the site offers home equity lenders from all over the country in one convenient location.
3. Get Your Paperwork in Order
Make sure your current lender has quick access to all your paperwork. The faster the processing time, the better your chances of locking in the best rate, so make sure the following records are in order:
- W2 earnings statements or 1099 DIV income statements for the last two years
- Federal tax returns for the last two years
- Bank statements for the last few months
- Recent paycheck stubs
- Proof of other income, such as tips, Social Security payments, etc.
- Proof of investment income
Ask potential lenders whether they need any other records as you get organized.
4. Check Your Credit Report
The cleaner your credit report is, the more leverage you have in securing the best rates. A credit health check begins at annualcreditreport.com, where you can request your latest report. You can obtain a copy of each of your major credit reports (Experian, Equifax, TransUnion) annually, for free.
This step is even more important these days, because lenders nationwide have taken huge losses on real estate lending and are more hesitant to take risks. Lending standards are much tougher, and even if you qualify, you may be disappointed by the amount of money you can borrow.
5. Select a Lender and Complete the Loan Application
A few tips as you near the end of the process:
- Decide if you want an adjustable or fixed interest rate. (Depending on your loan-to-value ratio and the lender you choose, you may not have a choice.)
- Some lenders will seek to refinance your first mortgage in exchange for a more attractive home equity loan rate. This can work in your favor, but it also can contain lots of surprises like balloon payments and adjustable rates on both the mortgage and the home equity loan. Be wary and do your homework on these combined offers.
Some lenders occasionally will offer up to 125% of a home’s value in a home equity loan. Avoid these offers, as you do not want your home equity loan to exceed the value of your home or you’ll run the risk of being overcome by unmanageable debt.
6. Sweat the Small Stuff
Read the fine print and pay attention to every detail. Look for a loan that does not include penalties if you are late with a payment. Some home equity loans contain penalty clauses whereby a single late payment triggers dramatic increases in the loan's interest rate and required monthly payment. Watch out for offers that include bundled insurance as well. You probably have adequate insurance coverage already, but it’s worth checking anyway.
The steps for opening a HELOC closely resemble those for home equity loans, but a few things to remember:
- Many HELOCs start with a low teaser rate that increases significantly after a set introductory period. Find out the floor and ceiling rates. The initial rate is almost always at floor, or the lowest allowable rate, and the only way to go is up. Make sure you do the math and determine whether you will be able to afford the rate increases. If your credit score is strong enough you may be able to lock in a fixed-rate HELOC.
- Some HELOCs only charge you interest for ten years, but then may charge you an additional fee that is due at the end of the loan’s terms.
Back to Table of Contents
In years past, second mortgage approvals were a snap as long as the home's value was properly documented. That isn't the case any longer. Lenders now look much more closely at borrower qualifications, demand higher FICO scores, more home equity, and full income documentation.
Not long ago, a borrower with a 630 FICO score could obtain a second loan fairly easily. Today, lenders prefer FICOs closer to 700. Lenders also have tightened requirements for loan-to-value ratios, or the amount of total mortgage debt outstanding relative to the home's market value. Many borrowers today will have access to only 70 or 75 percent loan-to-value, with the best borrowers reaching the 85% threshold.
As long as there are no problems seen in the credit report, the only requirement for a home equity loan is sufficient equity to secure the loan.. The interest rates and terms of the home equity loan may vary depending on your credit score, your home equity, and the amount of the loan. That’s why it’s so important to compare several different lenders to ensure you are getting the best rates and terms for your home equity loan.
There's no specific minimum income requirement to qualify for a HELOC, but the amount for which a borrower is approved depends on his ability to repay the equity loan while staying current on first-mortgage payments. No-documentation loans are very difficult to find. Therefore, just like with second mortgages and home equity loans borrowers need to document steady employment and stable income by supplying pay stubs and tax returns. The lender will compare the borrower's income with the amount he pays each month toward bills to determine how much is available for repayment of the loan.
Back to Table of Contents
If you have built up some equity in your home and your credit is in good shape, tapping your home’s value can help you in a variety of ways. If you have any questions about how home equity loans work, see the Wallet Hub Q&A section for more information.