Dangers and Pitfalls of 80/20 Loans

80/20 loans can help homebuyers with limited cash get into the home they want with no down payment and still avoid paying Private Mortgage Insurance. For buyers with cash but who want to save it for other investment opportunities, 80/20 loans can keep money in hand and out of being invested in a house. But their are dangers with 80/20 loans and the following can help you avoid the pitfalls.

Interest Pitfalls

An 80/20 loan is when a homebuyer takes a conventional mortgage on 80 percent of a home's purchase price and a second loan for 20 percent of the price. Lenders require you to get Private Mortgage Insurance if the loan-to-value ratio of the home is higher than 80 percent. Even though the additional 20 percent is borrowed, this still keeps your from the PMI requirement.

However, your interest rate will be higher than with a 20 percent down payment and an 80 percent loan. The rate on the 80 percent loan portion of 80/20 loans could be raised because your debt-to-income ratio is affected by the second loan. Lenders view you as a higher risk. But even if it is not, the second loan will have a higher rate of interest because that lender is in a second position in the event of default. The lender who is less likely to get paid in a foreclosure situation will charge more.

Additionally, you are paying interest on two loans, so your the actual cost and total interest expense will be higher with 80/20 loans, even if you have only a short-term 20 percent loan.

Equity Danger

In a conventional loan, even with a 10 percent down payment, you begin with 10 percent equity in your home. With 80/20 loans you have no equity until you begin building it by paying down the principal on both loans. This is a slow process as the interest payments are heavily weighted to the early years on mortgage loans.

Not only is equity slow to build, but even a slight downturn in housing values puts you in a negative equity position. At this point, if interest rates drop - which they typically do in a down housing market - you will not be able to refinance because you owe more on your home than it is worth.

Two Monthly Payments

For most homebuyers, one monthly payment represents 28 percent of their gross income. Whether the second loan puts you past that threshold or you still remain at it, you must determine if you can maintain paying two monthly payments on your mortgage and "piggyback loan," as 80/20 loans are also called.

Any change in your financial circumstances could make those double payments a burden.

Balloon Payment

Typical 80/20 loans have a conventional mortgage for 80 percent and an interest-only loan for the 20 percent, which is covering the down payment. That means you are not paying down the principal amount of the second loan and will owe it in a large balloon payment at the end of the loan term. The assumption is you will either have money to pay the loan off by that time or you will arrange for other financing.

However, recall the tenuous equity position 80/20 loans create. If housing values have gone down and you are in a negative equity position, it could be difficult to qualify for additional financing to pay off the balloon payment.