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Too Late to Combo?

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Posted On: 03/11/2009

Q: Can I still get a piggyback loan?

A: During the past few years many borrowers purchased a home with "piggyback" or "combo" financing, meaning a first loan for 80 percent or less of the purchase price and a second loan for most or all of the balance. The result was an ability to purchase real estate with little or nothing down plus a way to avoid the cost of private mortgage insurance.

While the cost of private mortgage insurance was eliminated, so was the insurance itself. Also, second liens often have a higher interest cost than first loans, so the money saved on PMI is offset by the additional money sometimes spent for a second loan.

Because there are two loans on the property and not just one, homes financed with piggyback mortgages are difficult if not impossible to refinance once the borrower gets in trouble. Here's why:

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Smith buys a home for $400,000. The purchase is financed with an 80-percent first lien for $320,000, a $60,000 second lien and $20,000 in cash (5 percent down).

Three years later the value of the property has fallen to $340,000 - a 15 percent decline. Interest rates are now down to 5 percent and Smith would like to refinance. Refinancing is fine with the first lender, but the second lender will only allow a refinance if Smith will pay off the debt, which was originally $60,000. Smith cannot refinance for enough to pay off both mortgages because the value of the property is substantially less than $380,000 - the total amount originally financed.

In practice, Smith will not be able to refinance the first loan. If the first loan is refinanced - if it is replaced with a new loan - it means the original second loan will become a first lien. The new lender would then have the second loan. However, a new lender will not want a second lien.

Here's why: When homes are foreclosed money from the sale of the property must be used to completely pay off the first lender before any money is made available for whoever holds the second loan. Given a large and growing number of foreclosures, second lien owners have taken a beating.

Notice that the size of the lien is not important. The issue is which lien was recorded first. The original second lien was recorded before any replacement financing, thus if the original first lien is paid off the original second lien moves forward to first place.

If borrower Smith has two fixed-rate loans a piggyback arrangement can work. However, many piggyback loans involve the use of two adjustable-rate mortgages, meaning that while the value of the property in this example is falling monthly costs can be rising. This is especially true if either or both loans are option-ARMs or some other form of toxic financing with a low "teaser" rate up-front.

How can this problem be solved so that Smith can refinance?

Smith can bring enough cash to closing to pay off the second lien in full, about $60,000 and then refinance the first lien. Since Smith and most people don't have $60,000 in cash, this option is unlikely

Alternatively, Smith and the first lender might enter into a loan "workout" - either a loan modification (say a new and lower interest rate for three years) or a repayment plan (if a payment has been missed). With a workout the original first loan is not replaced with new financing - thus it keeps its place as a first lien.

We have assumed to this point that Smith's payments are full and current. If that's the case then the first lender will have no reason to modify the loan. If Smith is behind on his payments, then the first lender may want to foreclose. (Since the property is likely to sell at a discount, with a forced sale the second lender's debt will likely to reduced or wiped out. The threat to the second lender could give some leverage to a borrower.)

In some jurisdictions, if Smith has "purchase money" mortgages used to acquire the home, then speak with a real-estate attorney to determine if one or both lenders have any recourse if Smith sells at a loss.

So, yes, combo loans are still out there. Are they as common as in the past? Nope. Are they good idea? Not any better than before - and if they involved adjustable-rate financing, a toxic loan format or a stated-income loan application then they weren't a good idea in the first place.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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