Second Mortgage…Where Art Thou?

Most financial events tend to have a ripple effect, leaving plenty of ulcers in their wake. The crisis in the subprime market is a prime example. The upheaval has affected many lending products, particularly the second mortgage.

Icarus was the Greek God whose wings caught fire when he flew too close to the sun. When it comes to mortgages, a similar phenomenon is occurring. Lenders who profited heavily from loose lending guidelines are feeling the Icarus effect. Not only have they been burned by foreclosures, but they've been forced to tighten up restrictions on loan products such as second mortgages. As a result, these loans are slowly vanishing from the marketplace.

First come, first served

The last few years have been like a lending smorgasbord for borrowers. Loans of virtually any shape or size were readily available. Lending restrictions were lax, and a borrower could pick and choose whatever she wanted. However, fallout from the subprime market-primarily an increase in foreclosure rates-has basically closed the loan buffet line.

Lenders have particularly tightened the guidelines on second mortgages. Why? Because in the event of a foreclosure, any money that a borrower has must be paid to the loan that's first in line-the first mortgage. If there were funds left over, they'd then be distributed to the second mortgage holder. For lenders in that second position, it's tough luck if the borrower can't make the payment.

To manage the increased risk, lenders now require excellent credit scores-somewhere in the range of 700 and above-and borrowers need to bring a fair amount of equity to the table. A homeowner will also be required to produce proof of available funds (investments or cash) to make the mortgage payments for up to a year.

Loan options are changing

The types of second mortgages, and how they're used, are changing as well. Because lenders are looking for more equity with each transaction, the "piggyback loan" has decreased in use.

The piggyback loan was used in the purchase of a house to avoid Private Mortgage Insurance (PMI), which is required when a borrower brings less than a 20 percent down payment to a closing. A first mortgage would make up 80 percent of the loan, and then the second mortgage would "piggyback" onto a small down payment to make up the remaining 20 percent. Now, many lenders require equity of 20 percent of a home's value in order to grant a second mortgage, effectively eliminating the piggyback loan.

Borrowers are not as eager to get rid of PMI, thanks to recent legislation that permits borrowers with $100,000 or less in annual income to deduct the insurance premiums from their taxes.

Does the slowdown spell doom for the second mortgage? Have the wings of high-flying lenders been singed beyond repair? The answer is most likely no. Markets have ups and downs; mortgage markets are no different. Second mortgages will make a comeback. And when they do, the opportunities for borrowers will by sky-high once again.