When should you take out a second mortgage?
The phrase itself might be a bit confusing: a “second mortgage?” If you already have one loan, why would you want a second one?
Well, second mortgages, also known as home equity loans, can be a low cost form of debt that helps you meet other financial goals. And in an age of historically low interest rates and home equity rising rapidly, it may be worth considering what a second mortgage can do for you.
What is a second mortgage and how does it work?
When people use the term “second mortgage,” they are generally referring to a home equity loan or a home equity line of credit (HELOC).
“A second mortgage is basically a loan on your property that takes a second position after your primary mortgage,” explains Matthieu stratman, senior financial advisor to the California Financial Planning Company, South Bay Planning Group.
Second mortgages, whether it’s a HELOC loan or a home equity loan, allow homeowners with enough equity in their homes to borrow against the assets. Equity is the value of your home calculated by subtracting your remaining loan amount from the total value of your home.
You can’t always borrow the full amount of your home’s value – experts typically say only up to 85% is what banks and lenders allow. For example, if your house is worth $ 400,000, the maximum amount most borrowers could take out on a loan would be $ 340,000. But if you have $ 200,000 left on your primary mortgage, you will have $ 140,000 of equity left to borrow.
Types of second mortgage
There are two main types of second mortgage: a home equity loan or a home equity line of credit (HELOC). A home equity loan allows you to borrow a sum of money at one time. Meanwhile, a HELOC works more like a credit card, allowing you to spend the balance up or down and only pay for what you use.
Here’s a more detailed breakdown of how each type of second mortgage works.
Home equity loan
A home equity loan works a lot like your primary mortgage. To qualify, you must provide the lender with all of your personal financial information. The lender will assess the value of your home and tell you how much home equity loan you qualify for. Then you can withdraw that amount of money as a lump sum, which would be repaid over a period of 20 or 30 years with interest.
One of the main advantages of home equity loans is the low interest rate, Stratman explains. Compared to credit cards and personal loans, mortgage rates are generally lower. Therefore, home equity loans can be ideally suited for home improvement projects that require an initial lump sum, but could potentially increase the value of your home down the road.
“The best way to use the equity in your home… would be to use it as something that adds future value to your property,” says Stratman.
Home equity loans are also a great tool for debt consolidation, according to Jodi Room, president of Nationwide Mortgage Bankers. If you have a fixed amount of debt in the form of student loans or credit cards, you can use the lump sum amount of a home equity loan to pay off the other debt all at once.
“This is when a home equity loan is more beneficial than a home equity line of credit,” says Hall.
However, home equity loans have some drawbacks. First of all, they add to your overall debt load, which can be risky if you don’t use it wisely or pay it off on time. You also add a second loan payment to your monthly bills. And, when you take out a home equity loan, you automatically start making payments on the entire balance, even if you don’t spend all the money right away.
A HELOC is a form of revolving credit, much like a credit card. You would apply for a HELOC the same way you would apply for a home equity loan, and the lender would give you an upper limit on how much you can spend. Your credit limit will likely be 85% or less of your home’s value. Lenders take your credit history and factors such as income into account when assigning your limit.
During the “Draw Period” you can spend up to your limit. When the drawdown period is over, you must then start repaying the amount you used.
“A home equity line of credit is really good if you want the ability to access it, but you might not know when you’ll need it,” Stratman says.
HELOCs can be useful if you need to fix an emergency roof leak, for example. But they can also be a good tool for larger, planned home renovations.
“Home equity lines of credit are positive when you’re doing, say, a renovation, where you may need different amounts of money throughout the process,” says Hall.
But be careful not to treat a HELOC like a credit card too much, Stratman warns. The money should be used for productive investments that potentially earns more than what you pay in interest.
Hall agrees: “I would warn people [against] use home equity for their current expenses, ”she says.
Second mortgage vs refinancing
Home refinancing is another common method of managing large expenses or strengthening your financial base. Second mortgages are not the same as refinancing. They can both help you save interest in two different ways.
Refinancing is basically restarting your primary mortgage, often with a lower interest rate or better terms. In contrast, you only save on interest with a second mortgage through arbitrage, which means you use the money borrowed from the second mortgage to pay off high interest debt or buy something that you would otherwise have used a mortgage for. high interest credit card.
Sometimes you can go for a cash refinance, where you take advantage of new equity in your home and get a lump sum by raising your mortgage closer to its original amount.
“If you have an immediate need for cash today, that cash refinance could be of use to something,” Stratman says. In addition, the interest rates on a refinance with withdrawal, because it is your primary mortgage, are generally lower than the interest rates on a second mortgage.
Refinancing can be more complex than a second mortgage and typically has higher upfront costs.
Here’s how to compare the differences:
Advantages and disadvantages of a second mortgage
Second mortgages can be used for many different purposes, but there are also some risks and drawbacks that you should be aware of.
Lower interest rates than other forms of debt, such as credit cards or personal loans
Can allow you to invest in your home and create more long-term value
HELOCs are flexible and you only pay for what you use
Adds to your overall debt amount
Add another loan payment to your monthly bills
HELOCs, if you’re not careful, can make you live beyond your means
Adding a second mortgage payment can be more costly than just refiing a withdrawal from your primary mortgage.
When should you consider a second mortgage?
One of the best times to consider a second mortgage, according to Stratman, is if you are planning major home renovations. Furnishing a new kitchen or adding a new bedroom, for example, are both an investment in your home that can significantly increase its value and a solid use of your home’s equity.
You might also want to consider a home equity line of credit to prepare for unexpected housing costs. In older homes especially, leaky roofs or old heating systems can eventually lead to costly repairs. Obtaining a HELOC could give you a way to pay it off with a much lower interest rate than on a credit card or personal loan.
“It really offers peace of mind,” Hall says.
Second mortgages are not only useful for real estate investments, they can also be a great way to consolidate other high interest debt.
But real estate investments aren’t the only reasons to consider a second mortgage: “Debt consolidation is one way people can use it wisely,” Stratman says.
Here’s how it might work: Let’s say you have a $ 15,000 credit card balance with an 18% interest rate. You could pay off the credit card using money from a second mortgage, which would have a significantly lower interest rate, and end up saving money in the long run.
Granted, there are also scenarios where you shouldn’t be using a second mortgage, Stratman and Hall said. If you’re struggling to manage your finances because you’re living beyond your means, a second mortgage will only make the problem worse and increase your debt load. Don’t use the money for a big lifestyle purchase – say, a luxury boat or car – that you wouldn’t otherwise be able to afford.
“The bottom line is that if you access money, try to use it in the most productive way possible without the equity money funding your lifestyle. If it is used responsibly. , that can be a good idea, ”Stratman says.