Understanding The 80-20 Mortgage Loan

What exactly is an 80-20 mortgage loan?  It's a way to get 100% financing for a home  purchase by simultaneously taking out two mortgages.  The first mortgage is for 80% of the purchase price (also called loan to value, or LTV).  A second mortgage for the remaining 20% of the purchase price is taken out at the same time.

Why Are 80-20 Mortgage Loans Popular?

The first reason that so many have turned to this option is because it is allows buying a house with no down payment.  In many cases, even the closing costs can be rolled into the mortgage.  For buyers with strong income but little cash on hand, this allows buying a home sooner than would be possible if they were forced to save for a normal down payment.  These mortgages were common during the housing boom period of 2000-2006.  Investors were particularly fond of these as it allowed buying more properties than they could if limited by the cash they had available.

The second reason for their popularity is that the 80-20 structure allows the borrower to avoid paying private mortage insurance, or PMI as lenders call it.  PMI can add a substantial amount to a borrower's monthly payment and only protects the lender (and not the borrower) in case of default.  This insurance is required by almost all lenders on residential loans exceeding 80% LTV.  Rather than having a single 90% LTV or 100% LTV loan with PMI required, the first mortgage of only 80% LTV does not have PMI.  The second mortgage of 20% will be at a higher interest rate than the first mortgage; however, this usually adds less to the monthly payment than the monthly cost of the PMI.

Note that most lenders have stopped offering 100% financing in any form to all except owner-occupants with truly outstanding credit, as default rates have skyrocketed in 2007-2008.  Investors with excellent credit and low debt to income may find a 5% down loan with enough searching.  Most lenders are now requiring 10% or more down payment on investment properties.

Even with small down payments now usually required, the same benefits of buying real estate with relatively little cash and avoiding the monthly cost of PMI are still obtainable.  

Are These Loans Safe For Investors?

Regardless of the loan structure, borrowing 100% of the value of a property is very risky for the home owner--and the lender.  The first problem for investors is that the monthly payment on any type of 100% financing will be higher than with a loan that included a down payment on the same property.  This makes it more difficult to get positive cash flow from collecting rents and paying the mortgage and other costs of owning and managing the property.  Both borrower and lender are assuming the borrower can still make the payments, whether from the property's income or that plus other cash from the borrower each month.  That may be a dangerous assumption--but it's not the biggest one.

The BIG assumption that both borrower and lender are making is that the value of the property will go up.  When this happens, the borrower builds enough equity over time to refinance the property into a single loan at 80% LTV or less.  This eliminates the second mortgage, probably reduces the borrower's monthly payment, and the lender earns another set of fees for processing another loan.  So far, so good provided 1) the borrower does not need to move before the house appreciates and 2) the house actually does appreciate.  

The sharp drop in home prices in most of the USA during 2007-2008 proves the old adage that "what goes up, must come down".  Borrowers with 80-20 loans or other forms of 100% financing now owe more than their home is worth in today's market.  Said another way, they're 'upside down' in terms of the value of their house versus what the owe on it.  In markets with steep price declines, many owe substantially more than their house is worth.

The key lesson here for investors is that leverage, which comes from borrowing money against the value of an asset like a home, is a twin edged sword.  It can greatly magnify returns when the value of a property increases and it's actually sold at the higher price.  However, it also magnifies the losses when prices are falling.  Unfortunately, many home owners and investors are now learning this lesson the hard way.   

Pay Attention To The Second Mortgage Terms

Let's assume that you've decided to move forward with an 80% LTV first mortgage and some amount in a second mortgage as well.  The lender's already explained that the second mortgage will be at a higher interest rate but it's still less in total each month than having one large mortgage with a PMI payment included.  You're still not quite safe yet.

First, pay close attention to the type of second mortgage being offered.  Is it a true second mortgage with a fixed payment each month for some number of years or is it a HELOC (home equity line of credit)?  With a HELOC, the payment may fluctuate each month as interest rates rise or fall?  Many lenders now offer HELOC's with fixed interest rates for the first few years.  Ask what's available with a fixed rate if your lender initially doesn't offer one to you. 

Second, the nasty surprise with a HELOC is that it affects your FICO score the same way as would a new credit card that you immediately charged up to 100% of your available credit.  That's one ding for taking on new credit and another, larger ding for having max'd out a revolving line of credit.  (You can learn more about FICO scores, get your score from all 3 credit bureaus, and learn how to improve your score at MyFico.com). 

While these last two points are potential issues with some types of second mortgages, don't let them scare you into paying PMI on one big mortgage unless there's a good financial reason to do so.  It's much tougher to get PMI removed from an investment property than for an owner-occupant so the savings from an 80-20 or similar type mortgage may go on longer than you initially expected.