Whether it’s a home improvement push, college tuition for that budding nuclear physicist or some other financial plan, a second mortgage might provide the answer. Before you start getting too serious about a second mortgage, though, it’s important to understand exactly what one is as well as how it differs from other home-equity-based financial products (not as simple as you might think).
A second mortgage is technically anything that places a second lien on your home, which would include Home Equity Lines of Credit (HELOCs) as well as traditional lump-sum second mortgages. The problem is some people use “second mortgage” interchangeably to describe both types of equity-based secondary loans, while others use “home-equity loan” in that manner, and still others use either “second mortgage” or “home equity loan” to describe those paid out in a lump sum and “HELOC” for those that involve a line of credit.
Is your head spinning yet?
Well, since it’s perhaps most accurate to refer to secondary home loans dispersed in the form of a lump sum as traditional second mortgages and those provided as a line of credit as HELOCs, we will stick with those naming conventions.
With that being said, there are a number of differences between traditional second mortgages and HELOCs, including the rates and, as alluded to already, the payouts. A traditional second mortgage typically has a fixed rate, a loan amount that is dispensed entirely at closing, and a term that ranges from 15 to 30 years. A home equity line of credit typically features an adjustable rate tied to the prime rate, and the homeowner can withdraw any percentage of the loan amount at any time during the draw period, which typically is the first 10 to 15 years of the loan, with the remaining term on the loan, typically the second half of the note, constituting the repayment period.
A traditional second mortgage offers you up to 85% of your home’s current equity in the form of a lump-sum dispersal. Interest is accrued and a monthly payment structure is set up, just like a standard mortgage loan. A home equity line of credit is granted using the same percentage system as a traditional second mortgage, but is issued in the form of a line of credit you can draw from in any amount up to the loan total that you need. Some lenders issue annual fees for having a HELOC account open, but most charge you accrued interest only as you spend the money. Your monthly payment is based on the amount you have spent. As you pay down what you owe, more funds become available in the line of credit.
Second mortgages for a fraction of your total mortgage value are much less costly than refinancing your whole mortgage, and typically require few or even no points and much lower closing costs. Interest on a second mortgage is tax deductible as well. As a result, a second mortgage offers the stability of a set monthly payment for the life of the loan, while a home equity line of credit requires you to pay a percentage of the total amount that you’ve drawn from the line.
Make no mistake about it, though, taking out a second mortgage is not a decision to be made lightly. If you have to foreclose on your home, its sale would cover the first mortgage, leaving only the proceeds that remain, if any, to repay the second mortgage. You could therefore be left holding the bag for a significant amount. That’s the major risk inherent in second mortgages, so you must make absolutely sure that the risk of foreclosure is minimal and that your need is serious enough to justify the decision.
The decision to go with a second mortgage instead of a home equity line of credit ultimately comes down to the amount of money you need and whether you can handle an additional monthly mortgage payment. If you need a large amount of money in one lump sum, then a second mortgage might be the option for you, provided your credit score is strong and you’ve built up a nice nest egg of equity in your home.
So, if you’re interested in shopping for a second mortgage, take the following steps:
- Make Sure You Have The Right Reasons for a Second Mortgage
Second mortgages are not an open-ended line of credit, so if it’s a grand European vacation you’re planning, you’re out of luck. Lenders consider home additions, major home repairs, educational expenses and emergency medical expenses as legitimate reasons for a second mortgage, and they’ll want details, quotes from contractors or documentation supporting your expenses. Make sure you can afford the additional payments involved in a second mortgage by running some calculations through a mortgage calculator and factoring the results into your monthly budget.
Far too often, consumers use a second mortgage to consolidate credit card debt, figuring that the lower interest rates will save them money. This is true, but unless you address your household budget, you’ll run the risk of accruing new credit card debt in addition to a second mortgage payment. Budget realistically, and if you’re using a second mortgage to consolidate debt, do so while also eliminating irresponsible credit use.
Also eliminate other options to a second mortgage. For example, think about simply increasing the length of your mortgage to lower your monthly payments, if you’re in a short-term financial jam.
- Get Your Home Appraised
Since your second mortgage will be based on the current market value of your home, an appraisal is the first step in the process. If the value of your home has appreciated considerably in recent years, then you’re in much better position to consider a second mortgage. On the other hand, if your home has dropped in value or is in a region of the country experiencing volatility in real estate prices, take that as a warning sign. If the value of your home were to decrease, a second mortgage on your home could lose its equity base.
To maximize your appraisal, take a few simple steps before you call the appraiser. First, if the exterior of your home and your lawn could use a little beautification, it’s a small improvement that can make a huge difference in the home’s value. Don’t spend a bunch of money on a landscaper – simply clean up, repair any torn window screens, clean the gutters and the driveway. Put away any clutter in the yard and of course, tidy up the interior of the home as well. First impressions matter when it comes to appraisals.
Have the following documents on hand for the appraisal:
- A copy of the blueprints or lot survey
- A list of any improvements made to the property since the purchase with costs detailed
- A list of any amenities that you’ve added, such as new kitchen appliances, countertops, decks or patios, security systems or improvements to the heating or air conditioning units.
- A copy of last year's tax assessment information
- A list of any fixed property to be sold with the home
- Check your Credit Report
The cleaner your credit report is, the more leverage you have in securing the best rates. A credit health check begins at annualcreditreport.com, where you can obtain a copy of each of your major credit reports (Experian, Equifax, TransUnion) annually, for free.
This is especially important during times when lenders have tightened their underwriting standards, such as might be the case during or immediately after a recession. Even if you qualify for a second mortgage with less-than-stellar credit, you may be disappointed by the relatively low amount of money you can borrow.
- Find Your Lender
If you’re happy with your first mortgage lender, start by checking with them to see if they will quote you a second mortgage, but don’t stop there: use Wallet Hub to comparison shop, as the site offers mortgage lenders from all over the country in one convenient location.
As you approach each lender, make sure you ask about closing costs, and whether the lender requires private mortgage insurance on a second mortgage. Lenders competing for second mortgages may be willing to reduce or even eliminate closing costs. You should only have interest and principal payments on a second mortgage. Interest rates for second mortgages tend to be a bit higher than primary mortgage rates, so it pays to shop around and to negotiate aggressively.
Read the fine print, and sweat the small stuff. Look for a loan that does not include penalties if you are late with a payment. Some second mortgages contain penalty clauses that mean that a single late payment triggers dramatic increases in the loan's interest rate and required monthly payment. Watch out for second mortgages that include bundled insurance as well. You probably have adequate insurance coverage already, but you should check anyway. Avoid second mortgages based on adjustable rate terms or that carry balloon payments as well.
Don’t be surprised if a lender is willing to lend you money far in excess of your home’s current value – and avoid doing so if possible. If your home’s value were to drop, you’d be left holding the bag.
- Before You Close, Pause and Make Sure You Know the Risks
It bears repeating that a second mortgage is a secondary lien on your home, and so it’s worth taking a deep breath and making sure you’ve thought through the decision.
Not only should you factor the second mortgage payments into you household budget, but you should make the payments a priority, as the higher interest rates on second mortgages make it imperative that this debt be paid down as quickly as possible.
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