Small down payment? Compare piggybacks, HELOCs and PMI

3 min read

The idea of a 20 percent down payment when buying a home is a relic of the past for many first-time home buyers. Smaller down payments mean buyers face the dilemma of either paying private mortgage insurance, or structuring their financing to avoid it. The choice is often whether to get a higher loan-to-value first mortgage requiring private mortgage insurance, or obtain a piggyback loan that avoids PMI.

A piggyback loan involves getting two loans simultaneously. The first is a mortgage worth 80 percent of the value of the property, enabling the borrower to avoid PMI. A second loan — generally equal to 10 or 15 percent of the value of the property — is then made, with the buyer’s required down payment comprising the remainder. These programs can also be referred to as 80-10-10 or 80-15-5 loans, for the percentage of the home’s value each component represents.

The disadvantage is that the borrowers could be saddling themselves to two loans for many years. Consider the example of a $200,000 house and a borrower using an 80-10-10 financing arrangement. In this case, the second loan is for $20,000. There are a couple decisions and drawbacks facing the borrower. Is the $20,000 borrowed on a fixed-rate home equity loan or variable-rate home equity line of credit? If borrowed on a HELOC, the attractive variable rate of today is one that is poised to increase with interest rates. By borrowing $20,000 at a variable rate, it’s likely the borrower will have to endure a series of interest rate hikes before the balance is retired. HELOCs have lower rates and lower required payments, but the borrower who wishes to pay off the loan on a schedule must make a devoted effort to pay down principal.

But if using a fixed-rate home equity loan, the rate will be higher than that of the HELOC and higher than that paid on the 80 percent loan-to-value first mortgage. The required monthly payment is also certain to be higher, particularly if the installment loan is amortized over a period such as five years. Stretching the term of the loan is one way to minimize the payment while still maintaining a fixed rate, but the borrower is subsequently married to two loan payments for a longer period.

One alternative that has benefited borrowers amid strong home price appreciation is borrowing more money on the first mortgage, forsaking a piggyback second mortgage, and just paying the private mortgage insurance each month. What, paying PMI? Blasphemy, you say. But home buyers venturing down this path are banking on continued appreciation that builds sufficient equity to dump the PMI more quickly than it would take to pay off the piggyback loan.

This road is lined with potholes, too, however. Given the higher loan-to-value borrowing that triggers the PMI, the borrower may also pay a higher rate on the first mortgage. Even in an age when homeowners have become accustomed to rampant price appreciation, eliminating PMI may be subject to seasoning requirements. In other words, the loan must age enough regardless of appreciation so that the borrower demonstrates the ability to make timely payments. Seasoning requirements can vary, from a minimum of two years and requiring equity of 25 percent to as long as five years with equity of 20 percent.

Further, this path will build equity at a slower pace than that of the piggyback loan. Why? The amount borrowed on the piggyback loan is added to equity over the period the balance is repaid. With the higher LTV loan, that amount is amortized over the same 30-year period as the original 80 percent borrowing. This trade is made in the interest of keeping monthly payments affordable in the initial years of the loan.

The discipline of retiring two loan balances simultaneously, and the larger equity stake that results, inflicts the pain of two payments now. In addition to avoiding PMI, borrowers also have better protection from potential price depreciation. Carrying a larger first mortgage and the accompanying PMI is a riskier strategy in the event of a price correction, as equity builds at a slower pace. Eliminating PMI is largely dependent on continued price appreciation, subject to seasoning requirements. If prices don’t appreciate, or instead depreciate, the borrower may be stuck paying PMI longer than intended, without the resulting equity stake of a piggyback loan.

Greg McBride is a financial analyst for

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