Have you ever heard a friend or family member joke about needing to “take on a second mortgage” to pay for something expensive, like a designer handbag or a fancy meal? If you’re not quite sure what that expression means, read on; while neither the bag nor the dinner is a worthwhile use for a second mortgage, your home can sometimes be a valuable source of credit.
What is a second mortgage?
Simply put, a second mortgage is a loan taken out against a home that already has a mortgage on it. You borrow using your home as collateral, so your interest rate is lower than, say, a credit card. But since your primary (first) mortgage lender is paid first, the second mortgage holder will probably charge higher interest rates than your original home loan carried.
Whereas first mortgages are the loans used in the initial purchase of the home, second mortgages are usually taken on by a property owner to finance other purchases or financial obligations, using the equity that has built up in the home as collateral on the loan. For example, let’s say a home is worth $300,000 and the remaining balance on the mortgage is $100,000. If the homeowner wishes to take out a second mortgage, she can borrow the difference between the home’s worth and the amount owed on the first mortgage. So in this case, the homeowner can borrow up to $100,000.
The most common types of second mortgages are known as home equity loans or home equity lines of credit (HELOCs). As the names imply, the former is a closed-ended loan where a homeowner borrows a fixed amount and pays it back over time; the latter is an open-ended loan where the homeowner borrows money against the home, pays it back, and then can continue to keep borrowing if necessary, similar to how one would use a credit card.
When should you consider a second mortgage?
Some of the most common uses for second mortgages include:
- Paying off high-interest debts
- Financing a home improvement
- Paying for an expensive medical treatment not covered by insurance
- Paying for a child’s college tuition
- Filling holes in a monthly budget after a job loss
As with all loans, there are benefits and drawbacks to taking on a second mortgage. In general, the interest rates on second mortgages are lower than the interest rates on other types of loans. If, for example, a homeowner has a $10,000 balance on a credit card that’s charging 17% interest, it may be smart to pay off the credit card with a home equity loan that only charges 7% interest. Also, the interest paid on second mortgages may be tax deductible if the money is used to buy, build or substantially improve the home. The deduction helps to offset some of the cost of taking on the loan.
The dangers of junior loans
However, there are many reasons to be cautious about taking on a second mortgage. For one, it’s important to remember that in taking on a second mortgage, you’re putting a lien against the roof over your head. If you fall on hard times and fail to pay the second mortgage, your home could be foreclosed on – even if you’ve paid off your first mortgage.
Also, many people take on second mortgages to pay off credit cards and auto loans, only to then max the cards out again or finance another vehicle. If you have an overspending problem and keep using your home’s equity to cover your bills, your home will likely never be paid off. Finally, as the recent housing crisis demonstrated, home values aren’t set in stone. If you take on a second mortgage and your home’s value falls, you could end up owing more on your home than it’s worth (this is what is meant by being “underwater” on a mortgage). Being underwater could make it very difficult for you to sell your home if you need to, and can lead to being foreclosed upon.
The decision to borrow money should never be an impulsive one – after all, debt can have a huge impact on your financial future. Nevertheless, though taking on a second mortgage should be considered carefully, in the right circumstances might be a smart move.
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