Your home equity loan or home equity line of credit could dash your dreams of reducing your monthly mortgage payment through a refinance. Blame a complicated mortgage-lending quirk known...
Compare Second Mortgage Rates!
By: Kirk Haverkamp
Updated and reviewed: Jul 9, 2013
One of the benefits of home ownership is that it allows you to use your home as collateral when you need to borrow money, by taking out a second mortgage.
Second mortgages offer several advantages over other types of borrowing. Interest rates are fairly low, particularly when compared to credit cards or other unsecured loans, and because they’re a type of mortgage, the interest is tax-deductable for most borrowers.
The downside is that you’re putting your home at risk if you can’t keep up the payments – it’s just like your primary mortgage in that respect. Borrowing against your home equity can also leave you exposed if home values fall, making it difficult to sell your home or refinance – second mortgages are a major reason that many homeowners ended up in negative equity, or “underwater” on their mortgages, when home values fell.
Types of second mortgages
There are three main types of second mortgages. The first is your standard home equity loan, where you borrow a certain amount of money and pay it back over time, usually as a fixed-rate loan. They’re useful if you need to borrow a set amount for a single purpose, like covering a tax bill.
The second is a home equity line of credit, or HELOC. With a HELOC, the bank sets a limit of how much you can borrow (a line of credit) and you draw against that as needed. You only pay interest on what you actually borrow. They’re useful if you need occasional amounts of money over a period of time, such as for a home improvement project. HELOCs have adjustable interest rates that can go up or down over time, but you can usually convert the accumulated debt to a fixed-rate loan once you’re down borrowing.
The third type is a piggyback loan, used in buying a home. These are fairly rare these days, but they used to be a fairly common way of getting around the requirements for a down payment. Borrowers would get a primary mortgage for 80 percent of the home value, then take out a second mortgage for the remaining 20 percent for their down payment.
This was a popular strategy for avoiding having to pay for private mortgage insurance (PMI), which is charged on standard mortgages with less than 20 percent down. Of course, this meant the borrower was often financing 100 percent of the home value, which few lenders are willing to do these days. You may be able to find lenders who will do a partial piggyback if you put down 5 or 10 percent, but only in areas with very stable home prices.
Can you still get one?
Prior to the bursting of the housing bubble, lenders were very willing to allow homeowners to take out second mortgages. In some cases, they would even allow them to borrow more than the home was worth (in combination with their primary mortgage), going as high as 125 percent of the home’s assessed value in total mortgage debt.
Those days are long gone, and lenders are much more careful about who they’ll give a second mortgage to. Generally speaking, you need to have good credit and a fair amount of equity in your home. Lenders are more willing to overlook a weak credit score if you have substantial equity, but most will limit second mortgages to 75-80 percent of your home value these days, minus whatever you owe on your first mortgage. (Some will go higher in areas with very stable or growing home values). But if you meet the criteria, yes, lenders are still doing these loans.
Second Mortgage vs. First Mortgage
Interest rates on second mortgages are typically higher than on a primary mortgage. That’s primarily because they’re a bigger risk for the lender – if the borrower defaults, the primary lender gets completely paid off with the proceeds from foreclosure before the secondary lender gets a dime.
On the other hand, second mortgages have much lower origination charges than primary mortgages, simply because there’s less money involved. That can make them an attractive alternative to a cash-out refinance (where you borrow against your home equity as part of refinancing your primary mortgage), which can have considerable origination fees.
How can you use the money?
Once you have a second mortgage, you can use the money for any purpose you wish – there are no requirements that it be used for any specific purpose, which make them a very flexible type of financing.
Many borrowers use them for such things as home improvements, paying for educational or medical expenses, starting a business or the like. It’s less common to hear of them being used for things such as vacations, buying boats or cars, or other indulgences the loans were frequently used for during the go-go days of the housing bubble.
Second mortgages can be a useful financial tool when used appropriately for necessary expenses. But they do add to your debt burden and leave you with less equity in your home should you decide to sell or refinance. It’s up to you to decide whether a second mortgage makes good financial sense for you.
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