Question: We want to purchase a home for $295,000. We spoke with a loan officer about financing with an FHA mortgage and found out we qualify. However, to get FHA financing we need to pay both an upfront-mortgage insurance premium and an annual mortgage insurance premium. This is a lot of money. Is there a way to cut out the insurance and use that money to reduce the mortgage?
Answer: If you purchase a home for $295,000 and finance with an FHA mortgage at 4.25 percent your costs will look roughly like this:
- The home costs $295,000
- The 3.5 percent down payment will be $10,325
- The base loan amount will be: $284,675
- The FHA has a 1.75 percent upfront mortgage insurance premium at this time, which here amounts to $4,982.
- Instead of paying the upfront premium in cash at closing you add $4,982 to the mortgage debt. There is now $289,657 to finance.
- The monthly payment for principal and interest is $1,425.
- The FHA also has an annual mortgage insurance premium equal to .85 percent of the outstanding mortgage debt. The monthly cost is $202.
- The cost for the FHA loan is $1,627 per month for principal, interest and mortgage insurance.
If you add up the insurance costs over five years, you have $4,982 up front plus an additional $12,120 ($202 x 60 months) over the life of the loan for a total of $17,102.
So yes, that’s a lot of money.
As an alternative, you might want to look into piggyback financing. Piggyback financing uses two loans, a first mortgage equal to 80 percent of the purchase price and a second loan equal to 5 percent, 10 percent, or 15 percent of the purchase price.
In other words, you can buy with as little as 5 percent down.
Let’s say that you have 80 percent financing at 4.25 percent and a 15-year second loan at 5 percent. Now the numbers look like this:
- The purchase price of the property is $295,000.
- You put down 5 percent or $14,750.
- The first loan is equal to $236,000. The monthly payment for principal and interest at 4.25 percent over 30 years is $1,160.98.
- The second loan is for $44,250. At 5 percent over 15 years the monthly cost is $349.93.
- The total monthly cost is $1,511.
Things To Consider
In the scenario above, the home buyer saves about $116 a month and pays nothing for insurance.
After five years, the FHA borrower owes $263,031 while the piggyback loans have a combined remaining balance of $247,297.
The FHA borrower had a $10,325 downpayment versus $14,750, a difference of $4,425. Notice that the $4,425 is not an interest cost, but a direct reduction of the amount owed.
In this example, the piggyback home buyer is ahead by $18,269 ($15,734 in the form of a smaller loan balance minus $4,425 in the form of a bigger down payment = $11,309 as well as $116 saved each month x 60 months = $6,960. In total, $11,309 plus $6,960 = $18,269).
The piggyback example constructed here is purposely conservative. Both loans are fixed-rate and self-amortizing, so there will never be a balloon payment.
After 15 years – if the financing is kept in place that long – the entire second loan will be repaid, thus cutting the home buyer’s monthly payments.
It’s possible to do piggyback loans differently. For instance, a home buyer might get a 10-year second note with payments scheduled on a 30-year basis. That will create a much lower monthly cost for the note but will also leave a balloon payment, something which represents a risk of not having the cash or credit to pay off the final payment.
As an example, imagine that you have a $30,000 second loan at five percent. If the monthly payments are calculated over a 30-year period, the cost each month for principal and interest will be $161.05.
If the loan is only outstanding 10 years the, balloon payment will be $24,402.
Piggyback loans can be a money saver for qualified home buyers, one with little upside risk if correctly structured. For specifics, speak with loan officers regarding piggyback loan options and ask them to run the numbers.