What is a second mortgage?: What are the advantages of second mortgages?

second mortgage

A second mortgage is a loan that allows you to borrow against the value of your home. Your home is an asset, and over time, that asset can gain in value.

Second mortgages, also known as Home Equity Lines of Credit 

What is a second mortgage?

Homebuyers who can’t pay for their homes upfront often opt for mortgages.

Once the homeowner has made significant progress on the first mortgage payment, they can seek approval for a second mortgage.

second mortgage is just an additional home loan that someone can take out to access more financing, more money on hand.

Second mortgages come in two different flavors: home equity loans and home equity lines of credit. Both allow homeowners to borrow against the equity in their homes.

Home equity loans are second mortgages that usually come with fixed interest rates, although some have variable rates. When you take out a home equity loan, you get the full amount of the loan at one time.

A home equity line of credit (HELOC), on the other hand, works more like a credit card. Instead of receiving a one-time payment, you’re allowed to borrow what you need when you need it, up to your credit limit.

HELOCs come with adjustable interest rates (meaning the interest rate you are charged will vary). You’ll use a credit card or write a check to get the money from your HELOC, and then make monthly payments to pay off the debt just like you would with a credit card.

Unlike first-time home loans, which typically come with 15 or 30-year loan terms, home equity loans and HELOCs typically pay off relatively quickly.

While they may have 30-year terms (especially if they are fixed-rate home equity loans), these mortgages tend to have payment periods that last anywhere from 5 to 15 years.

Second mortgages take advantage of your home equity, which is the market value of your home relative to the loan balances. Equity can go up or down, but ideally, it only grows over time.

How can the equity on my house vary?

Equity can change in several ways:

  • When you make monthly payments on your loan, you reduce your loan balance, which increases your home equity.
  • If your home appreciates because of an uptick in the real estate market or because of improvements you make to the home, your equity increases.
  • You lose equity when your home loses value or you borrow against your home.

What types of second mortgages are there?

Second mortgages can come in several different forms.

lump sum.

A standard second mortgage is a one-time loan that provides a lump sum of money that you can use for whatever you want.

With that type of loan, you’ll pay off the loan gradually over time, often with fixed monthly payments. With each payment, you pay a portion of your interest costs and a portion of your loan balance (this process is called amortization).

Credit line.

It is also possible to borrow using a line of credit, or a fund of money from which you can draw money. With that type of loan, you are never required to accept money, but you do have the option to if you want to. Your lender sets a maximum loan limit, and you can continue the loan (multiple times) until you reach that maximum limit.

Just like with a credit card, you can pay and borrow over and over again.

Rate Options.

Depending on the type of loan you use and your preferences, your loan may have a fixed interest rate to help you plan your payments for years to come. Variable-rate loans are also available and are the norm for lines of credit.

How much can you borrow?

The amount of money you can get depends on several things, such as the amount of equity you have in your home, your credit score, and the loan-to-value ratio (this is the percentage of the property that is mortgaged).

Most lenders you will NOT be loaned more than 75 to 85 percent of the loan-to-value ratio of your first and second mortgages combined.

That maximum would count all of your home loans, including first and second mortgages.

You do not have to get your second mortgage from the lender that gave you your original mortgage; You can get a second mortgage with almost any lender.

The important thing is to get a variety of quotes, including interest rates and total charges, and compare them.

What are the advantages of second mortgages?

Loan amount: Second mortgages allow you to borrow significant amounts. Because the loan is secured by your home (which is often worth a lot of money), you have access to more than you could without using your home as collateral.

Interest rates: Second mortgages often have lower interest rates than other types of debt. Again, securing the loan with your home helps because it reduces the risk to your lender.

Unlike unsecured personal loans like credit cards, second mortgage interest rates are typically in the single digits.

Tax benefits (especially before 2018): In some cases, you’ll get a deduction for interest paid on a second mortgage. There are numerous technicalities to be aware of, so ask your tax preparer before you start taking deductions.

Disadvantages of Second Mortgages

The benefits always come with trade-offs. The costs and risks mean that these loans must be used wisely.

Foreclosure risk: One of the biggest problems with a second mortgage is that you have to put your house on the line at risk.

If you stop making payments, your lender could take your home through foreclosure, which can cause serious problems for you and your family.

What is a foreclosure?

For this reason, it rarely makes sense to use a second mortgage for “current consumption” expenses.

For entertainment and regular living expenses, it’s simply not sustainable or worth the risk to use a home equity loan.

Cost: Second mortgages, like your purchase loan, can be expensive. You will have to pay numerous costs for things like credit checks, appraisals, origination fees, and more. Closing costs can easily add up to thousands of dollars. Even if you are promised a “no closing cost” loan, you still pay; it just doesn’t see those costs transparently.

Interest costs: Every time you borrow, you pay interest. Second mortgage rates are typically lower than credit card interest rates, but often slightly higher than the rate on your first loan. Second mortgage lenders take on more risk than the lender who made your first loan.

If you stop making payments, the second mortgage lender will not be paid unless and until the primary lender recovers all of its money. Because these loans are so large, the total interest cost can be significant.

Common uses of second mortgages

Choose wisely how you use your loan funds. It’s better to invest that money in something that will improve your net worth (or the value of your home) in the future. You will have to pay back these loans, they are risky and cost a lot of money.

  • Home improvements are a common option because you are supposed to pay off the loan when you sell your home at a higher selling price.
  • Avoiding Private Mortgage Insurance (PMI) may be possible with a combination of loans. For example, an 80/20 or piggyback loan strategy uses a second mortgage to keep your loan-to-value ratio above 80 percent on your first loan. Just make sure it makes sense compared to paying and then canceling PMI.
  • Debt consolidation: You can often get a lower interest rate with a second mortgage, but you could be switching from unsecured loans to a loan that could cost you your home.
  • Education: You may be able to prepare for a higher income. But as in other situations, you are creating a situation where you could face foreclosure. See if standard student loans are a better option.

What else can be done with the money from a second mortgage?

A lender will ask why you want a second mortgage on your loan application. You might think it’s none of the lender’s business, but lenders disagree with you.

Here are some reasons a lender might consider giving you the loan:

  • Remodel your home or home additions, like a new room.
  • General improvements to your home such as remodeling your bathroom.
  • Education (for example university studies)
  • Medical emergency
  • reliable investments
  • dependent care
  • debt consolidation
  • Transport
  • bail guarantee

Lenders prefer not to make loans to amortize assets. Ask your lender about special requirements for spending proceeds before applying for a second mortgage.

Also note that the Tax Cuts and Jobs Act of 2017 still allows an interest deduction on a second mortgage as long as the loan proceeds were used to buy, build, or improve a home.

Tips for getting a second mortgage

Compare prices and get quotes from at least three different sources. Be sure to include the following in your search:

  1. A local bank or credit union
  2. A mortgage broker or loan originator (ask your real estate agent for suggestions)
  3. an online lender

Prepare for the process by getting the money from the right places and having your documents ready. This will make the process much easier and less stressful.

Beware of the risky features of these types of loans.

Reasons to get a second mortgage

The interest rate and payment schedule may be more favorable on a second mortgage than refinancing your existing first mortgage into a larger loan. 

HELOC vs. Home Equity Loan: Which One Is Right For You?

The answer to this question is rarely black or white, there are plenty of grays in between. But there are some scenarios where the choice is obvious.

And if you borrow relatively small amounts and pay off the principal quickly, a line of credit may cost less than a home equity loan.

Credit Card Debt Consolidation: A Popular Use of Home Equity

Consumers with a lot of credit card debt often borrow a lump sum and pay off their high-interest bills. Often, they will save money because the interest rates for home equity loans and HELOCs are lower than those for credit cards.

Fixed-rate home equity loans are used more often than HELOCs for this purpose.

Why are second mortgages risky?

Before taking out a second mortgage, it’s important to consider the downsides of getting one. Ultimately, you will have to pay back the funds you borrowed. Because your home acts as your collateral (meaning it secures your loan), the lender can force you to foreclose on your home if you default on your second mortgage.

Second mortgages are subordinate to primary mortgages, so if you default on your loans, your first mortgage debt is paid off before the second mortgage lender receives anything.

For that reason, home equity loans and HELOCs are considered riskier than traditional mortgage loans. Therefore, they typically have higher interest rates.

In addition to higher mortgage rates, there are additional fees you’ll owe if you want a second mortgage. Closing costs on second mortgages can be 3% to 6% of your loan balance.

If you’re planning to refinance, having a second mortgage can make the entire process more difficult to navigate.

Home equity loan payments are generally easier to manage because you can set your budget knowing you’ll pay x amount of money each month for that second home loan.

However, since the amount you owe for a HELOC will vary, you may not be able to pay your bill if it is significantly more expensive than it was previously. And if you need a second mortgage to pay off existing debt, that extra loan could hurt your credit score and you could be stuck making payments to your lenders for years.

Are there income tax benefits to getting a second mortgage payment?

Second mortgages on the same property generally do not carry any special income tax benefits. However, if you take out a second mortgage on a new property, you will generally be allowed to deduct the interest on your first and second homes, as long as the total loan is less than $750,000, under the Tax Cuts Act and Jobs of 2017.

By Master James

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