“We are purchasing a $400,000 home that we want to finance with a 30-year fixed-rate mortgage. While we can more than afford the cost of a 20 percent down payment, I would prefer to keep my money in my investments instead. I was thinking of financing 100 percent (using an 80/20 to get out of paying PMI) but was unsure whether this type of loan structure would result in a higher interest rate on the first mortgage?”
Taking a 100 percent loan with a piggyback — a first mortgage for 80 percent of value and a second mortgage for 20 percent — would result in a higher overall cost than an 80 percent loan with a 20 percent down payment. In part, the higher cost will be in the higher rate on the second mortgage. But in addition, either the rate on the first mortgage will be higher, or the total loan fees will be higher.
To illustrate, on Oct. 17 I shopped for a purchase loan on a $400,000 property in California. If I put down 20 percent, I could get a 30-year, $320,000 fixed-rate mortgage at 5.75 percent, 1/2 point, and other lender fees of $4,770. If I went 100 percent and kept the first mortgage rate at 5.75 percent, the rate on the second mortgage of $80,000 was 8.15 percent, total points were 1.5, and other fees were $6,490.
Your intent is to invest the $80,000 that would otherwise go into a down payment. But a down payment is also an investment. The return consists of the reduction in upfront costs, lower interest payments in the future, and lower loan balances at the end of the period in which you expect to be in the house. I calculated the annual rate of return on investment in the case cited above, assuming you intended to be in the house for seven years. It was 15.6 percent before tax, and it carries no risk. Investments that good are not available in the marketplace.
Why is the return so high? When you take a 100 percent loan, even though you have the capacity to make a down payment, you place yourself in the same risk class as borrowers who have not been able to save for a down payment, and who have negative equity in their house the day they move in. The default rate of such borrowers is relatively high; they pay for it in the price of the piggyback (or in mortgage insurance); and you pay the same price as them.
You wouldn’t have your 17-year-old son purchase automobile insurance for your car. You wouldn’t buy life insurance and tell the insurer you are 10 years older than you really are. You shouldn’t take a 100 percent mortgage loan when you can afford to put 20 percent down.
Does Interest-Only Really Cost More?
“You say that it costs more for an interest-only loan, but my lender is giving me one for the same price. Is it possible that the professor is wrong about this?”
The professor has been wrong about some things, but he is not wrong about this. He has checked wholesale price quotes from many lenders, covering many different loan types. Invariably, if two loans are otherwise identical, the interest-only (IO) variant is priced higher.
The wholesale market is composed of very large lenders who fund mortgage brokers and smaller lenders, called “correspondents.” This market is extremely competitive, because the brokers and lenders who select from among the different wholesalers are knowledgeable and careful shoppers. That’s why I look to the wholesale market for evidence on price relationships among different mortgage types.
In the retail market, in contrast, these relationships can be obscured by a wide disparity in markups. Retail markups of the wholesale price vary both with the practices of retail loan providers, and with the sophistication and shopping acumen of borrowers.
Here is an example. Borrower A comparison shops online and finds the best deal on a 30-year fixed-rate mortgage is 6 percent with the IO version at 6.125 percent. Borrower B, who is identical except in smarts, is solicited by a high-priced lender who quotes 6.5 percent for the same mortgage, and when B asks about an IO, this lender generously offers it at the same price.
Conclusion: if your loan provider doesn’t charge extra for an IO, you know you are being overcharged.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.