What is a Second Mortgage?
If your home has built some equity, you can take out a second mortgage on it whenever you are in need of money. You may buy another property or keep the money for personal use like wedding, your child’s education or home improvements.
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While the prospect of getting some cash quickly by leveraging the equity may sound an existing idea, you should first get yourself familiar with all the obligations that come with a second mortgage.
Understanding the second mortgage
Let’s understand the concept of a second mortgage with an example.
When buying a home, a person takes out a mortgage by loan-to-income ratio and the property’s value. If the down payment is less than 20 percent of the property’s value, the borrower has to pay PMI on top of the installment amount.
Let’s assume the borrower has owned the home for two years and it has appreciated in value during this period. In other words, he has built equity. Now, he can take out a second mortgage on this property against the equity it has built.
The lender who provides the second mortgage would have a lien on the title. So there would be two liens, one for the first mortgage and the second for the second mortgage. The first mortgage which is usually the larger of the two is in the senior position, while the holder of the second mortgage is in the second position.
So if the borrower defaults on the mortgage and the property is foreclosed upon, the lender having the senior position will be paid in full before the holder of the second position gets any proceeds from the foreclosure sale.
In a nutshell, this makes second mortgages riskier for lenders, and as a result, lenders charge a slightly higher interest rate for these mortgages. The holder of the second mortgage has certain rights. You can’t refinance your first mortgage without getting approval from the holder of the second mortgage.
Choosing a second mortgage
A second mortgage comes into play in most people’s lives when they have to loom before them big expenditures. You may need money to fund a child’s education or buy a car.
People prefer second mortgages due to their flexible payment options.
There are two types of second mortgages:
You can take out the full amount of the loan and pay installments over a period just like a regular mortgage. You will pay fixed monthly payments during the amortization period.
You can also take out a line of credit loan. This type of loan is similar to a credit card loan. There will be a maximum limit to the amount of money you can borrow. The money will sit in the bank, and you can draw small amounts whenever you need to. With that type of loan, you don’t ever have to take any money, but you have the option to get the loan in full or in parts whenever you want. Like a credit card, you can repay and then borrow again.
When to apply for a second mortgage
Buying a home is the biggest financial investment in most people’s lives. A big chunk of your monthly income may go towards paying monthly installments.
It leaves most people with little or no spare money, so it may be difficult to arrange for funds in situations like a child’s wedding or education. You may want to start a new business, but feel tied up due to the lack of resources. In these situations, a second mortgage can be a great option.
Many people have to pay PMI because their down payment was less than 20 percent of the property’s value at the time of the purchase. But you can take out a second mortgage and pay off a portion of your first mortgage to avoid paying PMI.
Another consideration you have to make is how much money you can get when you apply for a second mortgage. It mainly depends on how much your home has appreciated in value since you purchased it or how much equity it has built.
Most lenders allow you to enable you to borrow 80 percent of your equity. Other factors such as loan-to-income and loan-to-value ratio also come into play.
Pros and cons of taking out a second mortgage
While there are advantages and disadvantages associated with every type of loan, here are a few specific considerations that you should make before committing to a second mortgage:
The biggest advantage of a second mortgage is that the cash is at your disposal whenever you need it. If you are financially strained because a significant portion of your income goes towards paying your first mortgage, you can use the proceeds from a second mortgage in exceptional circumstances that we have already mentioned.
You can use a second mortgage in place of a credit card loan.Compared to credit cards, the interest rate on a second mortgage will be lower.
The biggest disadvantage of a second mortgage is that you have a new lien on the property’s title, so your home is at risk because you have used it as collateral. If you default on the payments for your second mortgage, your home can be foreclosed even if you are keeping up with installments for your first mortgage.
You will have to pay all types of processing fees when taking out a second mortgage. It can be an additional financial burden.
Whether you should take out a second mortgage or not entirely depends on your personal circumstances. It is a great option if you can keep up with the payments and are sure that your financial situation is going to remain right in the future.
You should make sure to contact many lenders to get the best deal. In other words, don’t take a second mortgage lightly just because the amount is lower than the first mortgage. Shopping for the best deal can make a huge difference in the interest rate, and processing fee may vary from lender to lender.
Keep in mind when you take out a home equity loan, you don’t collateralize the entire value of your home. But since a second mortgage actually places the whole value of the home as collateral, it is much riskier for a borrower.
You can consult with a financial advisor to know if a second mortgage is the right choice for you.
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