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.
A second mortgage is a loan against your property that is in addition to your existing 1st mortgage. This loan is secured by real property with a mortgage note used as an instrument for repayment. The 2nd loan is also known as a subordinate lien and home equity loan. The second mortgage is held and recorded in 2nd position on the property deed.
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.
If a borrower defaults on a 2nd loan the first mortgage lender is paid prior to the second mortgage lender when the proceeds are dispersed from foreclosure. In the past second mortgage loans have had a higher default ratio. Considering the risk factor added to these subordinate home liens, most mortgage lenders will charge a higher percentage of points (also called origination fees).
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. A home equity line of credit is a loan in which the lender agrees to lend a maximum amount within an agreed period, where the collateral is the borrower’s equity in his/her house.With a HELOC, the bank sets a limit of how much you can borrow 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.
The third type is a piggyback loan, used in buying a home. A type of mortgage where a second mortgage or home equity loan is taken out by a borrower at the
same time the first mortgage is started or refinanced. Piggyback mortgages are frequently used to lower the loan-to-value ratio (LTV) of a first position mortgage to under 80%, thereby eliminating the need for private mortgage insurance (PMI).
These are fairly rare these days, but they used to be a fairly common way of getting around the requirements for a down payment.
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.
What are the limitations of a second mortgage?
Despite its various uses, a second mortgage is fraught with some limitations. These limitations are
- High chance of losing the home – By taking out this loan, you add to the risks of losing your home. If you fail to make payments on your second loan, you may end up losing your home. You need to ensure that the purpose for which you are taking out the loan is worth the risks that you are taking.
- Rate is higher than the rate on first loan – The rates on second mortgage are relatively higher than the rates on the first mortgage loans. This is so because in the event of default, it is the original mortgage which is repaid first. The repayment of the second mortgage is taken care of later.
- Fees may be hefty – Sometimes, a second mortgage may involve hefty fees. This adds to the costs of taking out the second loan.
Before you borrow a second mortgage, 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.