What is a Combination Loan?

A combination loan consists of two separate mortgage loans from the same lender, to the same borrower. One type of combination loan provides funding for the construction of a new home, followed by a conventional mortgage after construction is complete. Another type of combination loan provides two simultaneous loans for the purchase of an existing home. It's often used when the buyer can't come up with a 20% down payment but wants to avoid paying for private mortgage insurance (PMI).

How a Combination Loan Works

In the case of a new home, a combination loan usually consists of an adjustable-rate mortgage to finance the construction, followed by a second loan, typically a 30-year mortgage, once the home is finished. Typically, the second loan will be used to pay off the first one, leaving the borrower with just a single loan.

For someone buying an existing home, a combination loan may take the form of a piggyback or 80-10-10 mortgage. An 80-10-10 mortgage consists of two loans with one down payment. The primary loan covers 80% of the home's purchase price, the second loan another 10%, and the buyer makes a 10% cash down payment.

Because the primary loan has an 80% loan-to-value ratio, the buyer can usually avoid paying for private mortgage insurance (PMI), which is generally required when home buyers make down payments of less than 20%. PMI isn't a one-time expense but must be paid annually until the homeowner's equity reaches 20%. It generally costs borrowers an amount equal to 0.5% to 1% of their loan's value each year.

The second loan accounts for the rest of that 20% down payment. It will usually come in the form of a home equity line of credit (HELOC). A HELOC functions much like a credit card, but with a lower interest rate since the equity in the home backs it. As such, it incurs interest only when the borrower uses it.

A combination loan can help home buyers avoid the added cost of private mortgage insurance.

Pros and Cons of a Combination Loan

Using a combination loan to buy an existing home tends to be most common in active housing markets. As prices climb and homes become less affordable, piggyback mortgages let buyers borrow more money than their down payment might otherwise allow. That can be an advantage as long as buyers don't take on more debt than they can handle should something go wrong.

Combination loans can also be an option for people who are trying to buy a new home but haven't sold their current one yet. In that scenario, the buyer could use the HELOC to cover a portion of the down payment on the new home and then pay off the HELOC when the old house sells.

Buyers who are constructing a new home may have simpler or less expensive options than a combination loan. For example, the builder might finance the construction. Then, when the home is complete, the buyer can arrange for a regular mortgage and pay the builder. Alternatively, the homeowner might use a stand-alone construction loan and then shop for a permanent mortgage.

However, a combination loan may have an edge over two separate loans from different lenders, because of its one-time closing costs.