What Exactly is a Second Mortgage?
A second mortgage is basically a loan that you take against the equity that you have already built into your home. The proceeds from the second mortgage can generally be used for whatever purpose the borrower has in mind. It can be used to pay off a car loan or credit cards. The proceeds can be used for home improvement or to take a vacation. The money can even be put in a savings account for a rainy day fund.
Until a few years ago, the total amount of debt from the 1st and 2nd mortgages combined could exceed 80% of the total market value of the home. Recently however, low interest rates combined with a competitive marketplace have created a lending environment where some lenders have approved 2nd mortgages that, when combined with the balance due on the 1st mortgage, total as high as 125% of the home value.
Most financial advisors will warn you that carrying that much debt on your home is never a good idea. In my practice, I never recommend borrowing more than 100% of the value of your home and would rarely recommend a second mortgage with a loan to value of greater than 90%.
A second mortgage is always subordinate to the first mortgage. This means that in the event of a default, the property is sold and the proceeds are used to pay the first mortgage first, including any legal costs and other costs of the sale. The remaining proceeds are applied to the second mortgage. If there is not enough money remaining from the sale of the home, the second mortgage does not get paid.
A Higher Interest Rate
When determining the interest rate that a lender is willing to loan money out for a home mortgage, he looks at the risk level to him for loaning that money. This is the reason that a high risk borrower with a poor credit history gets charged a higher interest rate than a low risk borrower with a strong credit history.
The same theory holds true with a second mortgage. Because the lender of the second mortgage is second to be paid off in the event of a default, and because there is a greater chance that there might not be enough equity in the home to pay off the second mortgage in full, second mortgages are usually given at a higher interest rate than are first mortgages; irregardless of who the borrower is.
2nd Mortgage Terms
In general, the terms given for second mortgages are shorter than those for first mortgages - primarily because the dollar amount of the second is generally much lower than that of the first.
Second mortgage repayment terms can vary considerably, so it is important that you look around for the one that is best for you. For the most part they range in length from 5 to 20 years, with the majority of second mortgage loans being 10 to 15 years. A select number of lenders will offer a 30 year amortization and some of them will balloon (set a maturity date) of 15 years. This loan is called a 30 due in 15. Generally, just like first mortgages, the longer the maturity, the higher the interest rates. Also, just like first mortgages, the higher the credit score (FICO) the lower the interest rate.
Types of 2nd Mortgages
Just as the length of the second mortgage can vary, so can other repayment terms. However, the majority of second mortgages are paid back in equal monthly payments with a portion of the payment going to interest and a portion to the principal balance, just like a first mortgage.
The two most common types of second mortgages are the fixed rate and HELOC (home equity line of credit). The fixed rate mortgage is a standard offering. The HELOC is a little unique and has been very popular. This loan type typically calls for interest only payments for the first 5 to 10 years and then the line of credit is frozen at the outstanding balance of the loan. At that point, the loan payments are recast and a standard principal and interest payment is established for the remaining 10 to 20 years. HELOC’s are typically priced with a variable interest rate.
HELOC interest rates are similar to other loan pricing; the lower the FICO score and the higher the loan to value, the higher the interest rate.
When considering a second mortgage, do your homework and shop around to ensure that you get the best deal for you!