While rising interest rates have sharply reduced the number of mortgage borrowers who can refinance into a lower rate, rising home prices create opportunities for some borrowers to refinance into mortgages that are less costly in other respects.
One possibility, discussed in a previous column, is to refinance a mortgage carrying mortgage insurance into one that doesn’t require mortgage insurance [read Refinancing to Eliminate Mortgage Insurance].
Another possibility, the subject of this column, is to refinance a piggyback — a combination of a first and a (more costly) second mortgage — into a solo first mortgage.
Piggybacks that combined a first mortgage equal to 80 percent of property value with a second mortgage of five, 10, 15 or 20 percent of value grew rapidly during the years preceding the financial crisis. The major attraction to borrowers was that the monthly payment on the second mortgage was less than the alternative monthly mortgage insurance premium.
The lower payments on piggybacks reflected their modest interest rates — lenders under-estimated default risk because of the high rate of house price appreciation. A widespread practice, furthermore, was to make the payment of the second mortgage interest only for the first 10 years. In some cases, the second mortgage was an adjustable-rate home-equity line of credit, called a HELOC, with low initial rates but high potential for future rate increases.
The Crisis Shake-Out
The decline in house values associated with the financial crisis was the largest and most widespread decline since the 1930s. Many of the borrowers with piggyback loans found that the equity in their homes was negative, and the default rate on second mortgages soared.
While investors in second mortgages that had little or no equity protecting them had little incentive to foreclose, borrowers remained liable. The second mortgage lender could prevent the borrower from selling the house or modifying the terms of their first mortgage. Many borrowers discovered the hard way that when things go wrong, it is better to have mortgage insurance than a second mortgage.
Yet many piggyback borrowers survived the crisis unscathed. They did not default or tarnish their credit, and their homes are in areas where house prices have fully recovered. These borrowers could benefit from refinancing today.
The refinancing option for piggyback survivors
To examine the option, I assumed a home buyer paid $300,000 in May 2004, took a 30-year first mortgage of $240,000 at a fixed 5.5 percent and a piggyback for $60,000 at a fixed 7.5 percent, with interest-only payments for 10 years. I brought these loans up to date by amortizing the payments, taking account of the 10-year delay in amortizing the second. The balances on the first and second mortgages would be paid down to $173,179 and $53,810 as of June 2018.
I assumed that the value of the borrower’s house followed the pattern of national prices as measured by the house price series published by the Federal Housing Finance Agency. The average annual increase over the period May 2004 to June 2018 was only 2.35 percent because the period covered included the sharp price drop following the financial crisis in 2007. Using 2.35 percent as an estimate, the $300,000 house of May 2004 is worth $417,000 today. The current balance of the two mortgages, adding to $226,989 is only 54 percent of current property value.
The borrower can refinance without having to buy mortgage insurance or take another piggyback.
Assuming the owner’s credit is good, on June 8 she could have obtained a no-cash out refinance at 4.375 percent from one of the lenders who report their prices to my website, with a total upfront cost of $4,952. Entering these data in my calculator 3b, it would take only 18 months for the lower interest costs to cover the refinance cost.
If the borrower had a HELOC rather than a fixed-rate mortgage, the cost saving from refinancing would be smaller because of the lower interest rate. However, refinancing into a fixed-rate would eliminate the borrower’s exposure to a rate increase.
Post-Crisis Piggybacks
While new piggybacks disappeared for some years after the crisis, they began to emerge again three or four years ago. The earliest of them were just in time to benefit from an acceleration of house price increases. The house price index referred to earlier rose by 5.9 percent a year during the four years ending March 2018, and 6.3 percent during the final three years of that period.
A home purchased for $400,000 in 2014 that appreciated by 5.9 percent a year would be worth $506,000 after four years. This appreciation would allow the owner to refinance a 20 percent piggyback mortgage of $80,000, plus the existing first mortgage of $320,000 into a new first mortgage of $400,000.
In other words, post-crisis piggyback borrowers are able to refinance out of their original loans after just a few years, without having to suffer through a crisis. That’s their good fortune.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
