Second Mortgages: How They Work, Pros And Cons

Last Updated: June 2, 2019
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Have you ever wondered why homeowners actually take a second mortgage? Taking a Second mortgage could mean being able to receive a lump sum of money or open a new home equity line of credit (HELOC).  We've summarized everything you need to know - what is second mortgages, how they work and their pros and cons:

Have you ever wondered why homeowners actually take a second mortgage on their homes?

Taking a second mortgage could mean being able to receive a lump sum of money or open a new home equity line of credit (HELOC).  Your present equity will depend on the balance of your original mortgage loan and the present value of your home.

What Is a “Second” Mortgage?

By definition, there’s no difference between a home mortgage and a second mortgage.  It’s also a loan that you take out by using your home as your collateral – similar to what you did to purchase your home.

It’s only called “second” mortgage because it’s the second time you’ll be using your home to get a loan.  The first time you took out a loan with a lien on your house is the ”first” mortgage.

A second mortgage makes use of the equity in your home.  It is the appraised value of your home less the outstanding balance of your loan. Equity can increase or decrease although ideally, it should grow over time.  This is because the value of your property appreciates while your loan balance goes down as you make regular payments.  Here are the specific ways of how equity changes:

Every time that you pay your monthly payments on your loan, you reduce your loan balance.  This will increase your equity. If you make improvements in your home or it appreciates because of a strong real estate market, your equity also increases.

For example, if you have a $75,000 home loan against your house that has a value of $100,000, the difference of $25,000 is your equity.  When you decide to make use of that equity through a second mortgage, the bank will put a lien on your home.  That lien will give the lender the right to take possession of your house in case you default on your loan.

Types of Second Mortgages

Let’s dig a little deeper into the subject.  There are actually two main types of second mortgages. The first is the simple home equity loan and the second is the home equity line of credit (HELOC).  With the home equity loan, after you get an approval, the lender will give you a lump sum of money as a whole.  Then, you will have to pay it back at regular intervals over a set period of time (called ‘term’).  Usually, the insurance company fixes the interest rates on home equity loans.

For a HELOC, since this is a loan line, it will work similarly to a credit card.  You draw money when you need it and repay only based on the amount you’ve actually drawn.  The interest rates are usually adjustable (and negotiable).

Home equity loans/Lump sum

A standard second mortgage is a one-time transaction that will provide you with a lump sum of money that you can use for any purpose.  In this type of loan, the lender will require you to repay the loan gradually over time, typically by making regular fixed monthly payments.

Each time you make a monthly payment, you are paying off a portion of the loan balance (principal) and some financing charges (interest).  In business, this method called ‘amortization.’

A line of credit

At the other end, there’s a system called a line of credit.  Here, the lender sets aside a pre-determined pool of money for you where you can draw from as you want.  The line is available for a set period of time and the lender will not force you to draw any amount.  You can decide when and how much to borrow depending on your need for the funds.

The lender will tell you the maximum borrowing limit and you can borrow several times until you exhaust the limit.  Like a credit card, you can borrow and repay over and over as long as there’s a balance available from your active credit line.

Advantages and Disadvantages Of Second Mortgage

Let’s see how a second mortgage works from the point of their risks and benefits.

Benefits Of  Second Mortgage

Cash

Since the loan amount depends on the equity that has been built up in the home, they will allow the homeowner to borrow more.  Let’s not forget that there is no restriction for its purpose – the homeowner can use the loan for anything.  Credit cards and personal bank loans cannot compare in terms of size and scope.

They are usually lesser and not very flexible.  Many homeowners use a second mortgage to fund things like debt consolidation, home renovation, avoiding private mortgage insurance (PMI), college education or investments in real estate.  Other loans do not usually provide enough funds to cover big expenses or outlays like these.

Interest Rates & Private Mortgage Insurance

You might have heard of some people who take out both their primary and second mortgage about the same time of their home purchase.  This is often called a “piggyback loan” or a “purchase money second mortgage.”  Why do they do that?  It’s because they hope to lower their interest rate which will translate into significant savings.  Doing so can also help them avoid paying PMI – that is if they keep the primary loan at or below 80% of the value of the home.  If you can lower your interest rate and avoid having to pay PMI, you’ll be able to save thousands of dollars over the time you need to pay for your home.

Tax benefits (especially Pre-2018)

There is a chance that you’ll be able to get a deduction for the interests you pay on a second mortgage.  Tell you what though, it’s highly technical and there are so many provisions to be aware of.  So, better get the help of your tax accountant before you dive in and start taking deductions. The Tax Cuts and Jobs Act eliminated the deduction beginning the tax years after 2017 – unless you use the money for “substantial improvements” to your home.

Disadvantages Of  Second Mortgage

Remember this:  Even if banks consider second mortgages “safer”,  you must be aware of some major drawbacks when you borrow more money against your house.

Lose Your House

Here’s a warning:  If you, at any point, become unable to repay the loan, you risk losing your house.  And not only will the foreclosure be a traumatic thing – you will also probably ruin your credit.  The possibility of foreclosure only exists here and it does not come with other unsecured loans.  This particular risk should serve as a caution for you to consider thoroughly if you really need and are ready for a huge debt.  Be 100% certain that you can repay the loan and still maintain a decent standard of living (with provisions for emergencies) before you take a second mortgage.

No Additional Credit

If you take out a second mortgage, that’s it! Do not think you’ll be able to get the third one.  For one, the second mortgage usually exhausts what’s left in your home equity.  Even if there’s still some left, lenders would be wary to lend more because it would appear you’re heavily in debt.  In the short-term, this may look good but down the road, you will need some cushion.  Without a buffer, you might be unable to pay your bills should an emergency happens.

What’s worse, should you lose your source of income or the value of your home declines, you could end up with an underwater mortgage.  In this situation, you will have no way to sell your home and pay off your mortgage.  This lack of flexibility might lead you to file for bankruptcy when you find yourself at the bottom, financially.

Variable Credit

You’ve learned that home equity lines of credit usually come with a variable interest rate.  Nothing is permanent so your interest rates will go up or down while you are using your credit line.  A bout of bad timing could result in a significant increase in your monthly payment.

Therefore, it is important to evaluate your monthly expenses before you decide to get a home equity line of credit.  Be ready for rate spikes and the extra costs by setting aside some cushion money in your budget.  This way, if the rate suddenly goes up, you will not be financially vulnerable.

Cost

Second mortgages, similar to your first mortgage to purchase the house, are expensive.  A lot of costs come with it that you should pay.  You’ll pay for things like credit checks, appraisals, origination fees, and more.  The closing costs alone could set you back a few thousand dollars.

Do not fall for the promises of “no closing cost” loans.  You will end up paying for it, but they will not see that cost in the open.  They might hide it in some other costs but definitely, nothing is free.