What is a second mortgage?
If you’ve asked yourself that question before, you aren’t alone. Second mortgages have exploded in popularity over the past three decades, providing homeowners a way to get extra cash they can use to consolidate debt, pay for home renovations, pay for a down payment on a second and, in some cases, fund new cards, boats and vacations.
But what are second mortgages? How do they work? Are there risks involved and, more importantly, are they a good fit for every homeowner?
We wanted to know the answers to these questions, so we did our own research and reached out to mortgage lenders and brokers across the nation.
What we found is that second mortgages, although popular, need to be handled with the utmost financial care. While they may be popular, they aren’t always a good fit. Knowing when and how to use a second mortgage is just as important as knowing what they are.
In this guide, we’ll cover the following areas:
- What is a second mortgage?
- What types of second mortgages are there?
- What are the risks of a second mortgage?
- What should you spend your second mortgage on?
What Is a Second Mortgage?
A second mortgage is easy to explain – it’s the mortgage you get after your first mortgage. There are some details that you need to know, though, in order to understand how second mortgages work.
A “mortgage,” notes Adam Von Romer, a Glendale (CA) Century 21 real estate agent, is actually made up of two parts: the home and a promise to pay back your loan. When you get funding for your home, Romer said, you give the lender rights to your home (mortgage) along with your promise to pay back your loan (promissory note).
A big misconception, Von Romer told us, is that people who shop for second mortgages assume they’re getting a loan. While you are getting a loan, your house is put up as collateral, which means you could lose your home if you don’t pay the mortgage.
Because you’re putting up your home, your mortgage is known as a secured loan because you’ve secured the money by offering up the rights to your home. A personal loan, on the other hand, is known as an unsecured loan because you are offering anything up in exchange for the money.
What Types of Second Mortgages Are There?
As we talked about in the previous second, a second mortgage is basically you offering your house up for a second time in order to get money.
Unlike your first mortgage, which you use to get money to pay for your home, second mortgages are used to get cash for purchases that are much smaller than the cost of a home.
In this section, we'll cover two well-known second mortgages as well as one not-so-well-known option: home equity loans, home equity line of credit (HELOC) and piggyback loans.
“Equity” is a word you’ll hear often in this guide. The word refers to the difference between what your home is worth and how much you have left on your first mortgage.
Home Equity Loans
These loans are equivalent to the amount of equity you have in your home minus closing costs, which are the fees you pay for the work the lender puts in to process the loan.
These loans are also known as second mortgage cash-outs, because you’re cashing out the equity you have in your home.
“Typically, you can borrow up to 80% of the equity in your home,” said Brian Simmons, CEO of lending site Ask a Lender. “This money can be used for just about anything from college expenses to home renovation.”
Simmons went on to point out that these second mortgages are usually repaid over a shorter period of time than the usual 30-year first mortgage.
“They’re 10-20 years, generally, and they are often used for small amounts, like $10,000,” he said.
The payments you make on this mortgage will be fixed, which means you have one interest rate that doesn’t change. This an important point because a home equity line of credit typically has an interest rate that changes (variable rate).
Home Equity Line of Credit
A home equity line of credit, or HELOC, is like opening a credit card with a credit limit based on the equity in your home.
Joe Hogan, a certified financial planner with Florida-based Mariaca Wealth Management, told us that these lines of credit are take-it-or-leave-it scenarios.
“There is no requirement to take out any amount of the line of credit, but it is in place if needed,” Hogan said.
So, you could take out a HELOC when you’re entering a season of life where expenses may go up – perhaps due to an illness or a child going to college. Or, maybe you’re renovating parts of your home and you want some extra financial cushion just in case your expenses exceed the cash you’ve allotted to the project or projects.
Remember, though, that HELOC’s have several moving parts that you need to know about.
First, the interest rate you’re charged is tied to the prime rate set by the Federal Reserve or LIBOR, an interest rate that international banks use to set rates for their short-term loans.
So, if the prime rate or LIBOR rate goes up during your draw period, then your interest rates will go up and cost you more in interest payments. Conversely, if the prime and LIBOR rates drop, your interest rate will drop.
Second, your HELOC is broken up into two phases: draw and repayment. The draw phase is the amount of time your lender gives you to use money from the line of credit. If you take money out and then repay it, you free up more money, just like paying off the balance of a credit card.
“You can draw money from the line of credit to pay for any number of things, just like the second mortgage cash-out, and paying down the principal actually frees up more funds that you can draw upon,” Simmons said.
This draw period usually lasts around 10 years, he said, and, once it’s over, you’re responsible to pay the principal and interest that you didn’t pay off during your draw period. If you take money out during the draw period, you’ll have to make payments on what you withdraw and those payments include principal and interest.
Some lenders may offer HELOC’s in which you only pay interest during the draw period.
Because the amount of your line of credit is linked to the equity in your home, there could be instances in which the lender actually decreases your line of credit, says Alen Kadimyan, CEO of Glendale-based IEI Realty.
“The payments to these programs are adjustable and the amount of equity is accessed at each draw to justify the equity tied to the line of credit,” Kadimyan said. “If the values of the neighborhood and the property have declined the credit line could be decreased or completely closed by the lender.”
Because HELOC interest rates can go up and because a down market can reduce your equity and, consequently, your line of credit, these lines of credit are riskier than a home equity loan.
Simmons noted that there is another type of a second mortgage known as a “piggyback loan.”
These HELOC's are unique because they're used in conjunction with your first mortgage in order to avoid paying mortgage insurance on your home. A typical scenario is that someone buys a home for, say, $300,000.
To avoid mortgage insurance, you'll need to pay $60,000 down. You can only pay $30,000, so you get a $30,000 piggyback HELOC to make up the difference and thus avoid monthly private mortgage insurance payments.
So, instead of taking out a mortgage of $240,000, you're taking a mortgage of $240,000 and $30,000.
“These loans were very popular in the lead-up to the housing crash in 2007-2008, and fell out of favor afterward,” Simmons said, “but are starting to make a comeback as home prices have risen dramatically over the past few years.”
What Are the Risks of Second Mortgages?
Mortgage broker Fred Glick, a 32-year vet of the mortgage industry, said one of the biggest risks to getting a second mortgage is that many people don’t know they’re actually putting up their home as collateral to get the money.
“When a financial institution sells Home Equity Loans or Line, they do not tell people in plain English that they are getting a second mortgage put on their house,” Glick said. “I can’t tell you how many people have said to me that they have a home equity loan and had no idea that there was a lien recorded against their property.”
“Lien” refers to the fact that the lender has rights to your home if you decided not to pay back your loan.
Another risk of second mortgages is that they can create a financial disaster if you aren’t financially disciplined, Von Romer said.
“They are weapons of financial mass destruction in the wrong hands,” he said. “Only the most disciplined and sophisticated borrowers should even consider them.”
Exactly why they’re dangerous has to do with how the money is spent, which is something we’ll cover in the next section.
The final main risk of a second mortgage is the fact that your home’s equity can change. The U.S. housing crisis is a good example of this, Von Romer said.
“In the last cycle a huge number of homeowners say their equity sky-rocket and their ability to borrow expand drastically,” he pointed out. “Many took advantage of the opportunity and bought Mercedes Benz’s, vacation homes, Jet skis, and many other ‘consumer goods’ believing that real estate will only keep going up in value.”
As it turns out, home prices didn’t stay high; they crashed down. All that home equity that was used to leverage a home equity loan or HELOC disappeared. When homeowners tried to sell, they sold at a loss and were still on the hook for the equity-based loans they took out. They didn’t have homes, but they did have hefty loan or line-of-credit repayments.
What Should You Spend Your Second Mortgage On?
The mortgage brokers and financial experts we talked with warned against homeowners using their second mortgages to pay for consumer goods – items that won’t provide a good return on investment.
A good example of this comes from the quote that Adam Von Romer gave us. Before the housing crisis, people were buying cars, vacations and watercraft with their second mortgages.
Why the word of caution about these otherwise fun purchases? Because second mortgages are based on something that fluctuates: equity. If you home value dips and you decide to sell, you’ll have to scramble to pay off your loan or HELOC by selling whatever it is you bought. Or, you might just take the loss.
The experts we spoke with recommended using your HELOC or equity loan for things that return value.
“A disciplined borrower or sophisticated borrower is going to be somebody who borrows money on a credit line and use it to invest in another piece of real estate, stocks bonds or mutual funds that are going to have a higher yield than had they allowed the money to sit fallow in their home for principal residence,” Von Romer said.
Glick said HELOC’s can be a good tool if you invest in flipping homes but, again, it takes wisdom and savvy to do this well.
“A line of credit is a flexible vehicle to help people buy items like other homes where they fix and flip, pay down the credit line and then reuse it,” he said. “Others can use it for home improvements, debt consolidation, etc. when it is fiscally responsible.”
Another option for a second mortgage, Hogan said, is to use the second mortgage to pay off student loans. The advantage, he said, is that you can get tax breaks for the mortgage. Also, he said, unlike student loans, mortgage debt can be discharged in bankruptcy court.
The decision shouldn’t be taken lightly, though. By paying off your student loan debt with a second mortgage like the Fannie Mae cash-out refinance, you’re putting up your home as collateral if you don’t pay off the loan, whereas your home wasn’t mortgaged for your student loans.
“The borrower may be giving up valuable benefits of student loans such as loan forgiveness programs, income-based repayment options, and more,” Hogan said. “They should consult a qualified financial planner before making this decision.”
The Bottom Line
Second mortgages present you with the chance to leverage your home’s equity into cash that you can use any number of ways.
A home equity loan gives you a loan with fixed payments that you can use for whatever you’d like. The advantage of this type of loan is that the interest rate stays the same.
HELOC’s are another popular second mortgage. Unlike the home equity loan, this is a line of credit you can access, on average, for 10 years. Your interest rate goes up and down with the market and your lender may reduce your available credit if your home’s value decreases.
A piggyback HELOC can be a good way to make a down payment on a second home.
All of these options, though, have their drawbacks. You need to remember that, in each case, you’re offering up your home as collateral for the loan or line of credit. If you don’t pay what you owe, your lender could foreclose on your home.
Experts recommend that you use your money for things that will grow in value over time, but, if that’s your strategy, make sure you talk with a financial professional first.
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