The words "second mortgage" can conjure up thoughts of fear and desperation. This is because most people believe that you should only take out a second mortgage if you're dead broke and you've decided to raid your biggest asset – your home. However, taking out a second mortgage is not necessarily a move of financial desperation. In fact, there are some situations where it might be better to take out a second mortgage than to get a personal loan or refinance your first mortgage. The bottom line is that there are pros and cons to taking out a second mortgage. Before we examine those pros and cons, let's define second mortgage.
What Is A Second Mortgage?
In the simplest terms, a second mortgage is a mortgage taken out on a property that already has a mortgage associated with it. There are two different types of second mortgages. Both types of loans are secured by your home. This means that if you fail to make a mortgage payment, your lender can seize your home and sell it to repay the loan.
The first type of second mortgage is the home equity line of credit, also known as a HELOC. A HELOC is a loan that is secured by the positive equity value in your house. Your equity value is determined by taking the appraised value of your house and subtracting the amount owed on your first mortgage. Like a credit card, the balance on a HELOC is revolving which means that you can borrow as much or as little as you want to up to the credit limit that is established by your lender. You only pay interest on what you borrow. HELOCs generally have variable interest rates which fluctuate based on a publically available index. They also generally have a fixed time period during which you can borrow from your home equity line. After this time period, you may be able to renew your credit line.
The second type of second mortgage is the fixed-rate home equity loan. Like a HELOC, a fixed-rate home equity loan requires that you have positive equity in your home. Unlike a HELOC, this type of second mortgage has a fixed amount of money borrowed that is generally delivered to you in a lump sum. Fixed-rate home equity loans have fixed interest rates and a set repayment schedule like a traditional mortgage.
Why Would You Take Out A Second Mortgage?
There is only one reason to take out a second mortgage: You need money and a second mortgage is your only option, or it is your best option. Things tend to work out better if you take out a second mortgage because it is your best option. If it is your only option, it may mean you are not doing well financially because you can't get a personal loan or because you have very low spending limits on your credit cards.
What Are The Benefits Of A Second Mortgage?
Tax Deductions: The interest you pay on a mortgage – whether it is a first, second or third mortgage – is tax deductible which allows you to lower your taxable income. If you decide to get a personal loan or use a credit card to buy what you need, there are no tax advantages.
Lower Interest Rates: Interest rates are lower on a second mortgage than on personal loans or credit cards because the mortgage is secured by your property. Of course, your credit score and the nation's economy will also determine how low the interest rate will be. Keep in mind that interest rates on second mortgages will generally be higher than interest rates on first mortgages.
Access To A Large Pool Of Cash: As long as you have equity in your home and a decent credit profile, you can pull a significant amount of money out of your house.
Freedom: The money you receive from a second mortgage can be used for whatever you want, from home improvements to college tuition to debt consolidation. Some homeowners have even taken out a second mortgage to go on extravagant vacations or buy cars.
What Are The Disadvantages Of A Second Mortgage?
It's Risky: A second mortgage is secured by your house, so if you lose your job or experience financial hardship, you risk losing your house if you are unable to make payments on that second mortgage.
You Increase Your Debt Load: Taking out a second mortgage means adding a lot of debt to your house. If the housing market is slumping, the value of your house can fall below what you owe on it, and suddenly you go from having a lot of equity in your house to being "under water." If you have to sell your house, the proceeds from the sale might not cover the debt.
You Might Be Subjected To Variable Interest Rates: If your second mortgage is in the form of a HELOC, which comes with a variable interest rate, that rate could increase at some point, causing you to pay more for the money you borrowed and straining your budget.