If you need money for home improvements, to pay college tuition or another purpose, you might be able to secure funds with favorable terms through a second mortgage. Before you do so, it’s important to make sure you understand the terms and potential risks.
How Does a Second Mortgage Work?
A second mortgage is a loan that allows a homeowner to borrow against the value of their house by using it as collateral. A second mortgage draws upon the equity that has been accumulated. Equity can grow when mortgage payments lower the loan balance and/or when the value of the house increases due to renovations or a change in the real estate market.
The loan that was used to buy the home initially is the first mortgage and is secured with a lien on the house. A second mortgage can be subject to a fixed or variable interest rate. A second mortgage typically has an interest rate that is lower than rates for credit cards, but a little higher than the rate for the first mortgage. Some second mortgages have variable interest rates, which is good in this time of low interest rates in 2020 but can be dangerous if rates spike. Make sure you understand the way the interest rate is calculated and whether there are any limits on how high the rate can go.
Types of Second Mortgages
One option for a second mortgage is to receive a lump sum of money to be repaid over a period of time. A lump sum second mortgage would typically require monthly payments that consist of a portion of the loan balance and interest.
Another option is to open a home equity line of credit. You could borrow money once or several times, up to the available credit line, and gradually pay it back.
Pros and Cons
Since a second mortgage uses the house as collateral, you could probably borrow more than you would be able to through a conventional loan. The total amount that can be borrowed depends on the lender’s policies.
To obtain a second mortgage, you would need to pay for an appraisal, origination fees and a credit check, which could total thousands of dollars. Since a second mortgage uses a house as collateral, falling behind on your payments could put you at risk of foreclosure.
One benefit of a second mortgage is that it may be easier to repay the second mortgage than to refinance your first mortgage and then work on paying that down.
Why Get a Second Mortgage
Any time you take on debt you should think it through carefully. A second mortgage should only be used for a legitimate purpose that is likely to benefit you in the long run. For example, it would make sense to use a second mortgage to make repairs and improvements that would increase your home’s value and eventual sale price. A second mortgage could also be a good idea if you used the money to pay for a degree that could help you secure a job with a higher salary in the future. If you wanted to consolidate high-interest debts, you could obtain a lower interest rate through a second mortgage. You should check out what your payment will be before you go too far into the process.
Taking out a second mortgage for a big family trip is not a good idea. (I knew someone who did that and then lost her house. She said the trip wasn’t worth it in retrospect.) Using it to buy the car of your dreams is a bad idea too. Remember that if you fall behind on your car payment, the bank will take your car, but if you fall behind on the second mortgage that you took out to buy the car, the bank will leave your car alone but will take your home. If you are going to use a second mortgage to buy a car, then at least make it big enough to live in just in case you have to default on your mortgage!
Is a Second Mortgage Right for You?
Is a Second Mortgage Right for You?
A second mortgage can help you meet your long-term financial or life goals but should not be used
to treat yourself to luxuries like travel or a fancy car. Before you take on a new loan using your home as collateral, be sure that you understand how it works and what the limits are on the rates and make sure you can afford the monthly payments in order to avoid the risk of foreclosure. The financial crisis of 2008 was due in part to people treating the equity in their home like checking accounts and accumulating more debt than they could afford.