Ups and Downs of Second Mortgages

Knowing the good and the bad of second mortgages can help you keep your personal finances in tip-top shape.

In the board game Chutes and Ladders, a roll of the die can send you skyrocketing towards the finish line or plummeting back to the start. If you aren't careful, your second mortgage can have an equally unexpected influence on your life and on the state of your personal finances.

Second mortgage basics

When you need to tap into your home equity, the second mortgage might be the answer. Second mortgages are available as either fixed-rate loans, or adjustable-rate home equity lines of credit (HELOCs).  Either type can be funded without altering your first mortgage debt facility. The documentation required during the application process for a second mortgage is straightforward, and the closing costs are generally low. You can borrow up to 80 percent of the home's value, less the amount owed on your first mortgage. Some lenders will offer you even more money, depending on the strength of real estate values in your neighborhood.

Second Mortgage Ups

Second mortgages have three compelling features: tax deductibility, competitive interest rates, and versatility.

Taxes. The IRS allows you to deduct the interest paid up to the first $100,000 of second mortgage debt. This alone makes the second mortgage more attractive and affordable than non-deductible personal debt.

Interest rates. The interest expense of borrowing money against your home is lower than it would be to borrow money without collateral. This is related to the risk involved for the lender; if you default on a second mortgage, the lender can take your property. If you default on an unsecured loan, the lender has a much harder time recovering the unpaid debt. When the lender's risk is lower, you benefit with a more competitive interest rate.

Versatility. You can use cash generated by a second mortgage for any purpose.

Second Mortgage Downs

While the second mortgage has its advantages, there are risks involved too:

Foreclosure. The second mortgage is secured by your property-and that has some pretty serious implications if you start missing payments. The risk of foreclosure should be thoughtfully considered, particularly if you plan to use the second mortgage to consolidate unsecured debt.

Overspending. The versatility of the second mortgage can be a good thing-or it can be a bad thing. Ideally, you should spend the funds from your second mortgage on things that will provide a return in the future. Examples include college tuition, home improvement, or business start-ups. If you spend the money too frivolously, you'll be strapped with a monthly debt payment with little else to show for it.

Taking out a second mortgage shouldn't be a game of chance. With proper planning, you're the one who decides whether to climb the ladder or slide down the chute.