How Do 80/20 Loans Work?

Grant Conversion

• If a government agency subsidizes this second, 20 percent loan, the home buyer may not have to pay it back under certain conditions and will receive the home equity. The City of South Bend, Ind., for example, has established a home loan program in which the second loan can be transformed into a grant. This program is only available to low-income residents.
  
  

Incentive Program

• A government agency may establish additional requirements to provide urban renewal in an area. Michigan's 80/20 loan program applies to areas of cities, such as Detroit, that the government wishes to revitalize. An 80/20 loan program may also help a home buyer get a second mortgage for a house that the previous buyer abandoned or a house that the bank foreclosed upon.
  
  

Buyer Protection

• It is possible for the same lender to provide both the initial 80 percent loan and the second 20 percent loan. According to the state of Oregon, this structure can remove some of the borrower's protections from the lender during a foreclosure or a short sale, so Oregon passed a law that prevents the lender from attempting to collect on the second loan if the borrower has to sell the house for less than the value of the first mortgage.
  
  

Risks

• Since the value of the first and the second loan add up to 100 percent of the purchase price, the home buyer purchases the house with zero down payment. A loan with no down payment creates risk for the bank because any drop in the home value leaves the homeowner with negative equity, so the bank cannot fully cover a foreclosure loss by selling the house. The bank is better protected from risk if a government agency provides the second, riskier 20 percent loan.
  
  

Combo Loans

• An 80/20 loan is a type of combo loan. There are other types of combo loans available, such as 80/15/5, which includes a first mortgage of 80 percent, a second mortgage of 15 percent and a down payment of 5 percent. A homeowner may even have a third mortgage. According to Florida State University, combo loans became popular in the late-1990's because they allowed a home buyer who couldn't afford a 20 percent down payment to avoid having to pay for private mortgage insurance.