Loan options overview -> MI vs. HELOC ‘piggyback’

MI vs. HELOC ‘piggyback’

Whether you choose MI or a HELOC ‘piggyback’ is influenced by issues around
tax deductibility, qualifying, interest rate, cash flow, your sensitivity to
interest rate risk, and your exit strategy.

When putting down less than 20% on a purchase, you need to speak with a lender about your options. There are a limited number of conventional loan programs that allow down payments of less than 10%, including the ones from FHA and VA. These loans are only available for conforming (up to $417,000) and high-balance conforming (up to $625,500) loan amounts, except for VA loans which can go much higher.

With at least 10% but less than 20% down, unless you are getting a VA loan, you have only two options:
  • pay a mortgage insurance premium (MI) either monthly or in the form of a higher interest rate
  • obtain a home equity line of credit (HELOC), which is often referred to as a piggyback when it is used with a purchase mortgage.

 
If you choose MI there are two ways to pay for it: through a monthly premium paid with your mortgage or through a higher interest rate. A typical monthly mortgage insurance premium on a $500,000 loan is at least $250. If you pay the mortgage insurance premium upfront in a lump sum, on a $500,000 loan that premium would be around $8500. Because borrowers who need MI have limited funds, this lump sum is usually paid with a credit from the lender which is generated by raising the interest rate for the loan, typically by a quarter point or more. Simply put: with MI you have two choices, a monthly premium or a higher rate.

If you choose the HELOC rather than MI, you get two mortgages: a first mortgage at 80% of the purchase price which can have a fixed interest rate, and a second mortgage with an adjustable rate, a HELOC, to make up the difference between the down payment and the first mortgage. Currently, HELOCs require at least a 10% down payment, 15% for larger loan amounts.

Choosing between paying MI Monthly, accepting a higher rate in lieu of monthly MI, or taking an adjustable rate HELOC Piggyback is a complex calculation. The factors that come into play include your tolerance for interest rate risk, how long you will own the property, how quickly your home will appreciate, and what total monthly payment you might need to qualify. What follows are some of the differences between having MI and a HELOC piggyback:

Tax deduction

HELOC Piggyback or Higher Rate: tax deductible
MI: tax deduction has expired, renewal uncertain
The payment on a HELOC is tax-deductible mortgage interest, subject to the usual IRS rules on home mortgage deductions. The MI payment was made tax deductible after the 2008 housing crisis. That deduction has expired and may not be renewed.

monthly payment

HELOC: lower initial monthly housing expense
MI or Higher Rate: higher initial monthly housing expense
Because the HELOC payment is interest only at a relatively low rate it is less expensive monthly than having to pay MI, or having one loan at a higher rate. Example - on a home purchase of $500,000 with 10% down payment:

  • MI: first mortgage $450,000 at 4.50%, payment $2280 + MI $248 = total payment $2528
  • MI built into the rate: $450,000 at 4.75%, total payment $2347
  • HELOC piggyback: first mortgage $400,000 at 4.5%, payment $2027 + HELOC payment $218 = total payment $2245

NOTE: The lower payment with the piggyback may help you qualify. Also, it seems obvious to opt for ‘MI built into the rate’ at 4.75% instead of monthly MI because the payment is lower; however, as your equity builds through the combination of paying principal on the first and property appreciation, you may be able to cancel the monthly MI in as little as 24 months and almost certainly within 5 years. If you chose the higher rate option of ‘MI built into the rate’ you may have that higher interest rate for a very long time, making that option more expensive the longer you keep the loan.

interest rate

HELOC: monthly adjustable rate can increase sharply to as high as 18%
MI or Higher Rate:
 payment/interest rate can never increase
If you have chosen monthly MI, your MI premium cannot increase and at some point will disappear; you have the peace of mind that comes from knowing your housing expense can only go down. If you opt for a higher rate with MI built in, your entire mortgage will have a fixed rate, and the payment can never increase. If you have the HELOC the payment, although relatively small, could more than triple in an environment of extremely high rates.

exit strategies

Here are some ways to potentially shift out of the increased expense of a low down payment loan structure over time:

  • HELOC: A HELOC can be paid off by a refinance or by using your savings. Some HELOCs require that the borrowers pay off and close the HELOC within 10 or 15 years. Depending on your financial situation at that time, this could potentially be a hardship, especially if you are planning to be retired by then.
  • MI: Mortgage insurance can be cancelled at no charge after you have built sufficient equity, unless you have an FHA loan. With any FHA loan originated after May of 2013, the only way out of the MI is with a refinance.
  • Higher Rate: If you have chosen a higher interest rate instead of MI, that rate can only be lowered if you refinance at a lower interest rate after your property has appreciated to the point that it has 20% or more equity.