Taking out two mortgages on the same house simultaneously may sound like a bad idea at first glance, but "piggyback loans" are a common way to make a smaller down payment or avoid paying...
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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.
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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.
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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Disadvantages of Second Mortgages
Optimists love to look on the bright side of things. But when it comes to financial products like second mortgages, they also need to look at the not-so-bright side. Second mortgages have many advantages, but they have weighty disadvantages, too. In any financial transaction, it's important to be aware of all your potential risks.
Second mortgage defined
In many ways, a second mortgage is a duplicate of your first. It's a loan secured against your house, and the interest you pay is tax deductible. The difference occurs in the event that you default on your loan. The lender who holds the primary mortgage is the first to receive any funds recovered from the defaulted loan. The second mortgage lender is next in line. Because second mortgages are a slightly riskier proposition for lenders, they're generally tagged with higher interest rates.
If you've built up quite a bit of equity in your home, a second mortgage allows you to tap large sums of money at one time. How you use the funds is entirely your decision. Typical uses include home improvements, paying for college, debt consolidation, and even paying for private mortgage insurance.
A walk on the dark side
All the plusses of having a loan secured against your house can turn into a huge minus if you fail to make your mortgage payment. A bank could foreclose on your home if you default on this loan and your primary mortgage.
That's the worst-case scenario, but there are even more potential disadvantages. Late payments can include hefty fees and serious blights to your credit report. And while second mortgage interest rates generally beat the rates of credit cards, they're generally higher than first mortgage rates.
There's plenty to celebrate about second mortgages but, like seconds at the dinner table, they can also get you sick to your stomach if you can't handle the extra load. Whether it's digesting a meal or digesting a mortgage loan, make sure that you have the stomach for it.
Avoid High Jumbo Loan Rates with a Second Mortgage
High-ticket purchases of real estate usually require loans that are so large, they don't conform to the federal guidelines for conventional loans. These are called Jumbo Loans. Mortgage interest rates are normally a quarter of a percentage point higher for Jumbo Loans than they are for conventional loans. One way to avoid the Jumbo Mortgage is to divide your loan into two parts a first and a second mortgage.
To keep up with inflation, the government adjusts the ceiling for Jumbo Loans each year, based on the movement of prices within the housing market. Each time they raise the bar, the definition of a Jumbo Loan changes, and you're allowed to borrow a higher amount with a conventional type of loan.
If you plan to borrow in 2006, you're in luck. The limit was raised for this year and is now $417,000. That's a whopping 16 percent higher than last year, and almost $100,000 more than it was just a few years ago.
If you use a Jumbo Loan and borrow $450,000, for example, you'll likely pay $100 to $150 more per month than with a conventional loan, because of the higher rate of interest. During the life of a 30-year loan, that higher interest could cost you an additional $40,000. To lower the amount of your mortgage so that it still meets the guidelines for conventional loans, you may want to consider splitting it into two parts. That means, with regard to this example, you could borrow $416,000 with a conventional loan at a lower interest rate and then take out a second mortgage for the remaining balance of $34,000.
Before you borrow an amount above the prevailing conventional loan amount, talk to lenders about the possibility of using a second loan in tandem with a first as a way to minimize the impact of higher interest rates. You might discover that you can save a little money each month, and a considerable amount of money during the next two or three decades.
Benefits of second mortgages
Tailor the loan to your lifestyle. You can pick the second mortgage that best matches your needs for cash. A HELOC, for example, is very similar in functionality to a credit card. It comes with a credit limit, allowing you to access funds whenever you need them. Many people use this to cover their kids' annual tuition bills. On the other hand, a home equity loan gives you all the cash at once, but it's locked into a set interest rate and regular monthly payments. (The rates on a HELOC are generally tied to the prime interest rate.)
Quick cash without crippling fees. If you haven't noticed lately, the competition among lenders is furious. That's great news for you, because you can generally get the second mortgage of your choice for minimal closing costs.
Tax deductible. One of the greatest perks of a second mortgage is the fact that the money you pay for interest can be tax deductible. Providing your second mortgage doesn't exceed $100,000, you can generally claim the interest expense on your taxes.
For many borrowers, the significant advantages to a second mortgage loan make it the ideal solution for solving those short-term cash flow problems. However, before you start looking for a lender, make sure that this quick cash will be used for prudent, reasonable expenses, and not just to make a few extra trips to the shopping mall. Think like a business when it comes to running your household, and only dip into the power of a second mortgage when it's truly necessary.
Understanding the Secondary Mortgage Market
You've just been notified that your bank has recently sold your mortgage. Although unsettling, this is a very normal business transaction that will not affect your loan.
It's another day of junk mail, when all of a sudden, you see an envelope from your mortgage company. You're about to toss it, but open it just to see what they have to say. Your heart jumps into your throat and you can't breathe when you read that the company that gave you the money to buy your dream home has just sold your mortgage. What does that mean? Is it even legal? What happens next?
Take a deep breath--this is a perfectly normal scenario. Financial institutions can sell mortgages without your consent. This is legal and does not affect your mortgage in any way. The name on the envelope may change, but that's all. Not convinced? Confused? Let's start at the beginning.
Primary mortgage market
You originally applied for your mortgage from a bank, mortgage company, or credit union. This is called your primary market mortgage lender. If they think that you're a good risk, the lender will give you the money to buy the house. You, in turn, promise to pay it back under certain pre-defined conditions. After the closing, the primary lender may either hold on to your mortgage, or sell it in the secondary market.
Secondary mortgage market
There are companies who buy primary mortgages, package them into securities, and sell them to investors on Wall Street. This is called the secondary market, and is actually a good thing, because enough money is made on the secondary mortgage market to help keep your interest rates low. Once your mortgage is sold, the new lender keeps all the terms and conditions of your loan. The only difference you'll notice is that the address on the envelope containing your payment will change.
You'll receive a letter notifying you that your mortgage company has sold your home loan. After that, you'll get another letter from the company that has bought it. This new letter will identify them as the new lender, and inform you that the terms and conditions of your loan won't change. Instructions will also arrive explaining how to make your payments to the new company. If you have questions, or if your mortgage payment is imminently due, you could give them a call.
Mortgages are bought and sold by banks and financial institutions all the time, and actually helps stimulate the housing market, and keep interest rates down. Lenders are required by law to notify you of the transaction, but it will not affect your mortgage in any way except where the payment gets made. This is all perfectly normal and legal, and nothing for you to worry about…so start breathing again!
Top Three Reasons to Take a Second Mortgage
Like a snowflake, no two borrowers are alike. We all have different financial needs, assets and long-term goals. But we do share some similarities in different loan-specific scenarios. In each of the three following cases, we're going to illustrate why a second mortgage is the ideal lending choice instead of using another mortgage tool, like a cash-out mortgage refinancing.
- Low rate on your first mortgage. Interest rates generally follow a roller-coaster trend, experiencing a fair amount of ups and downs over the years. Unfortunately, the dips in interest rates don't always correspond to the times when you might need to tap your equity. If you're currently at a low rate on your first mortgage, performing a cash-out refinance on your first mortgage may increase your monthly payment and add long-term interest dollars to your bottom line. Crunch some numbers You may find that a second mortgage would be a better short-term solution. Keep in mind that when interest rates on first mortgages dip back down, you can refinance and roll that second mortgage into your first.
- Avoiding a pre-payment penalty. Lenders make money if a loan is on their books for a certain length of time. If a borrower refinances before the stipulated amount of time is over, the lender loses. That's why many lenders often tack a "pre-payment penalty" onto a first mortgage. The amount of the payment varies, but it can be generally quite expensive. The goal of the penalty is to prevent borrowers from constantly refinancing their first mortgages. Because many pre-payment penalties can equal up to six months of interest charges, they tend to discourage frequent refinancings. If you have a pre-payment penalty written into your first mortgage, you might find that even a slightly higher interest rate will help you come out ahead in the long run, especially when you consider the minimal closing costs of a second mortgage.
- Smaller fees. Borrowers tend to focus on the interest savings with a home mortgage refinance, but closing costs, including the steep fees charged by lenders and vendors, can be substantial. The fees for a second mortgage are minimal in comparison. And, if you have a strong credit rating, they can be non-existent.
All borrowers are different. But as you can see above, there are common scenarios when it comes to loans. If you find yourself in one of these familiar places, a second mortgage can save you quite a bit of money.
Finding Funds Second Mortgage or 401(k)
Your 401(k) is a tremendous investment tool. And while many people would never touch their nest egg until it comes time for a comfy retirement, you are permitted to borrow from the fund in the form of a short-term loan. While this choice does exist as an option, there are many reasons why you should chose a flexible second mortgage instead.
Looking at your best interest
If you're weighing the options of a 401(k) versus a second mortgage loan, it's important to do a little math. Let's say you were taking out a second mortgage for $10,000 and leaving your retirement account alone. First, calculate the interest rate you'd pay to the lender minus the tax savings you would realize from deductions. For this example, assume you're in the 25 percent tax bracket, and you're borrowing at an interest rate of 8 percent. To determine the after-tax cost of this loan, use the following formula 8*(1-.25), (8 is the interest rate, and .25 is your tax bracket). The result? You'd pay a net of 6 percent on the money you borrow-or $600.
Now, look at your 401(k) account. Let's assume it returns a growth rate of 9 percent, which is the average annual long-term return of the S&P 500. On $10,000, that would equal $900. If you were to borrow $10,000 from your 401(k) instead of choosing a second mortgage, the money wouldn't have the opportunity to grow. In effect, it would "cost" you that $900, which is $300 more than the cost of the second mortgage.
The actual interest would be calculated differently, based on the specific investment or second mortgage you choose, but the underlying concept holds true.
The above calculation does not take into account eventual taxes on the 401(k) plan, but it's too difficult to calculate the future rate when you retire, unless your crystal ball is very clear.
Hidden costs of 401(k) loans
If you borrow from your 401(k), you have five years to pay back the loan, and your plan administrator is required to charge you interest-none of which is tax-deductible. Also, if you borrow against your 401(k) and subsequently lose your job, you will need to repay the loan within one to two months. No such penalty exists, of course, for a second mortgage.
The bottom line is that borrowing against your 401(k) will likely cost you more in the long-run. When it comes to solving a monetary problem, consider the net interest rate difference, as well as the cost of borrowing from your 401(k). You'll see that a second mortgage loan should be your first option.
Second mortgage facts
They always come in second The second mortgage loan is called a "second" because it's a lien on your property that's placed behind your first mortgage. This order is crucial to your lenders. In the event that you default on your loan and your property is sold, the lender that holds the first mortgage is at the front of the line for the proceeds from the sale. Once that first mortgage has been satisfied-including all legal costs, costs of sale, etc.-the lender that holds the second mortgage receives whatever funds are left. As a result, a lender perceives the second mortgage to be a slightly riskier proposition, a fact which influences the next two items.
More risk, higher rates Because of the higher risk, a lender adjusts its rate accordingly. Second mortgages generally carry higher rates, no matter how pristine your credit report may be. But despite this increase, the interest you'll pay on a second mortgage almost always trumps what you would pay on a credit card. Factor in tax-deductibility (there's a $100,000 limit on how much of the loan can be deducted), and this lending option remains a solid possibility for most borrowers.
Terms of varying lengths Borrowers will find that second mortgage terms will be shorter, due to smaller loan amounts. These terms vary, with the most common length being 5-10 years. There are loans that are longer than that, as well as ones that are considerably shorter. When evaluating the choice that's right for you, be sure to calculate the amount of long-term interest you'll spend on loans with longer terms. The figures can be quite unsettling.
Interest vs. principal Second mortgages vary in terms of how much money is paid toward principal on a loan. On a fixed-rate, fixed-term second mortgage (called a home equity loan), a set amount of money is designated for both interest and principal. On a home equity line of credit, the only set amount is a minimum interest payment. It's up to the borrower to determine how much he would like to direct toward interest and/or principal above and beyond that amount.
The facts helped Joe Friday bring plenty of wrongdoers to justice. Now that you're armed with the facts on a second mortgage, you should be able to detect the loan that's right for you.
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