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The phrase itself may seem a bit daunting: a “second mortgage?” If you already have one, why would you want a second one?
Well, second mortgages – also known as home equity loans – can be an inexpensive form of debt that will help you achieve other financial goals. And at a time when interest rates are historically low and home equity is rising rapidly, it can be worth thinking about what a second mortgage can do for you.
What is a second mortgage and how does it work?
When people use the term “second mortgage” they are usually referring to a home equity loan or home line of credit (HELOC).
“A second mortgage is essentially a loan on your property that takes on a second position after your main mortgage,” said Matthew Stratman, senior financial advisor at South Bay Planning Group, California.
Second mortgages, be it a HELOC or home equity loan, allow homeowners with enough equity in their homes to borrow against the asset. Equity is the value of your home, which is calculated by subtracting your remaining loan amount from the total value of your home.
You can’t always borrow the total value of your home – experts generally say banks and lenders only allow up to 85%. For example, if your home is worth $ 400,000, most borrowers can borrow no more than $ 340,000. But if you have $ 200,000 to pay off your main mortgage, that leaves you with $ 140,000 in equity.
Types of secondary mortgages
There are two main types of second mortgage: a home equity loan or a home equity line of credit (HELOC). A home loan enables you to borrow one lump sum at a time. In the meantime, a HELOC works more like a credit card, so you can add or subtract the balance and only pay for what you use.
Here’s a more detailed breakdown of how each type of second mortgage works.
A home loan works much like your home mortgage. To qualify for one, you must provide all of your personal financial information to the lender. The lender evaluates the value of your home and tells you how much of a home loan you qualify for. Then you can withdraw this amount of money as a lump sum, which is paid back with interest over a period of 20 or 30 years.
One of the greatest advantages of home equity loans are the low interest rates, says Stratman. Compared to credit cards and personal loans, mortgage rates are usually lower. Hence, home equity loans can be a good solution for home renovation projects that require a lump sum upfront but can potentially add value to your home over time.
“The best way to put equity in your home … would be if you actually use it as something that will add future value to your property,” says Stratman.
Home loans are also a great debt consolidation tool, says Jodi Hall, president of Nationwide Mortgage Bankers. If you have a set amount of debt in the form of student loans or credit cards, you can use the cash on a home loan to pay off the other debts at once.
“Then a home equity loan is cheaper than a home equity line of credit,” says Hall.
However, there are some drawbacks to home equity loans. First of all, they add to your overall debt burden, which can be risky if you don’t use them wisely or don’t pay them back on time. Also, add a second loan payment to your monthly bills. And when you take out a home equity loan, you automatically start paying the full balance even if you don’t spend the money right away.
A HELOC is a form of revolving credit, similar to a credit card. You would apply for a HELOC the same way you would apply for a home loan, and the lender would put a cap on your spending. Your credit limit will likely be 85% of the value of your home or less. Lenders take your credit history and factors such as income into account when assigning your limit.
During the “Draw Period” you can spend up to your limit. After the withdrawal period has expired, you will need to repay the amount you used.
“A home equity line of credit is really good when you want the availability to access it but you might not know when you’ll need it,” says Stratman.
HELOCs can come in handy when, for example, you need to fix a roof leak in an emergency. But they can also be a good tool for larger, planned house renovations.
“Home equity credit lines are positive if you’re doing a remodel, for example, that may require different amounts of money throughout the process,” Hall says.
But be careful not to treat a HELOC too much like a credit card, warns Stratman. The money should be used for productive investments that may return more than you pay in interest.
Hall agrees, “I would warn people [against] use the equity in the home for their daily living expenses, ”she says.
Second mortgage vs. refinancing
Home refinancing is another common way to tackle larger expenses or strengthen your financial footing. Second mortgages are not just refinancing. Both can help you save on interest in two different ways.
A refinance is when you essentially restart your home mortgage – often with a lower interest rate or better terms. On the other hand, you only save interest on a second mortgage through arbitrage, ie you use the money from the second mortgage to pay off high-interest debts or to buy something for which you would otherwise have used a high-interest credit card.
Sometimes you can get access to a cash out refinance where you take new equity in your home and receive a lump sum in cash by increasing your mortgage loan closer to its original amount.
“If you need the money right now today, that payout refinance could serve a purpose,” says Stratman. In addition, since it is your main mortgage, the interest rates on a cash-out refinance are usually lower than the interest rates on a secondary mortgage.
Refinancing can be more complex than a second mortgage and usually has higher up-front costs.
How to Compare the Differences:
Advantages and disadvantages of a second mortgage
Second mortgages can serve many different purposes, but you should also be aware of the risks and shortcomings.
Lower interest rates than other forms of credit such as credit cards or personal loans
Can allow you to invest in your home and add more value in the long run
HELOCs are flexible and you only pay for what you use
Increases your total debt
Adds another loan payment to your monthly bills
If you are not careful, HELOCs can lead you to live beyond your means
Adding a second mortgage payment can be more expensive than simply paying off your main mortgage
When should you consider a second mortgage?
One of the best times to consider a second mortgage, Stratman says, is when you are planning a major home renovation. For example, installing a new kitchen or adding a new bedroom are investments in your own home that are likely to increase the value of your home significantly and make sustainable use of your home assets.
You can also consider a line of credit for home equity loans to prepare for unexpected housing costs. Leaky roofs or old heating systems can lead to costly repairs over time, especially in apartments in old buildings. When you secure a HELOC loan, you can pay it at a much lower interest rate than a credit card or personal loan.
“It really offers peace of mind,” says Hall.
Second mortgages aren’t just great for home equity investments – they can also be a great way to consolidate other high-yield debt.
But home investments aren’t the only reasons to consider a second mortgage: “Debt consolidation is one option that people can use wisely,” says Stratman.
Here’s how it might work: Let’s say you have $ 15,000 on credit card with an interest rate of 18%. You could pay off the credit card with money from a second mortgage that would have a significantly lower interest rate and save money in the long run.
Of course, there are also some scenarios where you shouldn’t get a second mortgage, Stratman and Hall said. If you are having trouble keeping up with your finances because you are living beyond your means, a second mortgage will only make the problem worse and increase your debt burden. Don’t use the money on a big lifestyle purchase – say, a boat or a fancy car – that you otherwise couldn’t afford.
“The main thing is, when you access the money, try to use it as productively as possible without the equity money funding your lifestyle. If used responsibly, it can be a good idea, ”says Stratman.