Second Mortgages – Advantages and Disadvantages
A second mortgage is a loan that lets you borrow against the value of your home. Your home is an asset, and over time, that asset can gain value. Second mortgages, also known as home equity lines of credit (HELOCs) are a way to put that asset towards other projects and goals.
What is a Second Mortgage?
A second mortgage is a loan that uses your home as collateral – similar to a loan you might have used to purchase your home.
The loan is known as a “second” mortgage because your purchase loan is often the first loan that is secured by a lien on your home.
Second mortgages tap into the equity in your home, which you might have built up with monthly payments or through market value increases.
Loans can come in several different forms.
Lump sum: a standard second mortgage is a one-time loan that provides a lump sum of money you can use for whatever you want. With that type of loan, you’ll repay the loan gradually over time, often with fixed monthly payments. With each payment, you pay a portion of the interest costs and a portion of your loan balance (this process is called amortization).
Line of credit: it’s also possible to borrow using a line of credit, or a pool of money that you can draw from. With that type of loan, you don’t ever have to take any money – but you have the option to do so if you want to. You’ll get a maximum borrowing limit, and you can continue borrowing (multiple times) until you reach that maximum limit.
Like a credit card, you can even repay and then borrow again.
Rate choices: depending on the type of loan you use (and your preferences), your loan might come with a fixed interest rate that helps you plan your payments for years to come. Variable rate loans are also available and are the norm for lines of credit.
Advantages of Second Mortgages
Loan amount: second mortgages allow you to borrow a large amount. Because the loan is secured against your home (which is generally worth a lot of money), you have access to more than you could get without using your home as collateral. How much can you borrow? It depends on your lender, but you might expect to borrow (counting all of your loans – first and second mortgages) up to 80% of your home’s value.
Interest rates: second mortgages often have lower interest rates than other types of debt. Again, securing the loan with your home helps you because it reduces the risk for your lender. Unlike unsecured personal loans like credit cards, second mortgage interest rates are commonly in the single digits.
Tax benefits: in some cases, you’ll get a deduction for interest paid on a second mortgage. There are numerous technicalities to be aware of, so ask your tax preparer before you start taking deductions. For more information, learn about the mortgage interest deduction.
Disadvantages of Second Mortgages
Of course, life is full of tradeoffs. Be aware of the pitfalls of using a second mortgage. The costs and risks mean that these loans should be used wisely.
Risk of foreclosure: one of the biggest problems with a second mortgage is that you have to put your home on the line.
If you stop making payments, your lender will be able to take your home through foreclosure, which can cause serious problems for you and your family. For that reason, it rarely makes sense to use a second mortgage for “current consumption” costs such as entertainment and regular living expenses – it’s just not sustainable or worth the risk.
Cost: second mortgages, like your purchase loan, can be expensive. You’ll need to pay numerous costs for things like credit checks, appraisals, origination fees, and more. Even if you’re promised a “no closing cost” loan, you’re still paying – you just won’t see those costs transparently.
Interest costs: any time you borrow, you’re paying interest. Second mortgage rates are typically lower than credit card interest rates, but they’re often slightly higher than your first loan’s rate.
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Second mortgage lenders take more risk than the lender who made your first loan. If you stop making payments, the second mortgage lender won’t get paid unless and until the first lender gets all of their money back.
Common Uses of Second Mortgages
Choose wisely how you use funds from your loan. It’s best to put that money towards something that will improve your net worth (or your home’s value) in the future – because you need to repay that loan.
- Home improvements are a common choice because the assumption is that you’ll repay the loan when you sell your home with a higher sales price
- Avoiding private mortgage insurance (PMI) might be possible with a combination of loans – just make sure it makes sense compared to paying – and then canceling – PMI
- Debt consolidation: you can often get a lower rate, but you might be switching from unsecured loans to a loan that could cost you your house
- Education: as with other situations, you’re creating a situation where you could face foreclosure. See if standard student loans are a better option
Tips for Getting a Second Mortgage
Shop around and get quotes from at least three different sources. Be sure to include the following in your search:
Get prepared for the process by getting money into the right places and getting your documents ready. This will make the process much easier and less stressful.
Beware of dangerous loan features. Most conventional loans do not have these problems, but it’s worth keeping an eye out for them: