Talking about major financials decisions can be awkward and confusing. There’s a lot of misinformation out there when it comes to finances, especially in the case of second mortgages, which rely on market value and equity of a house you are currently paying a mortgage on.
Second mortgages can be very beneficial when used the right way and for the right purposes, but they can also be a risky endeavor when used incorrectly.
San Diego Bankruptcy Attorney specializes in serious financial decisions, including second mortgages. We understand the lender market and the logistics that go into obtaining one as well as the legal rights and responsibilities you have or take on when opting for a second mortgage. We have helped numerous clients across San Diego determine whether a second mortgage is right for them, and we’ve helped many clients fight unfair treatment.
We put together the following overview of second mortgages as a starting point for you to understand second mortgages and whether one is the best option for you. This information is not intended as legal advice. Speak with a professional attorney who understands your specific situation to obtain legal counsel.
Understanding second mortgages
A second mortgage is a loan that you can take out that uses your house as collateral even as the house is still under loan (mortgage). That means you are taking a loan out against the current value of your home, and if you are unable to pay, your house could be seized. Second mortgages are also known as junior-liens because a (senior) lien already exists on your first mortgage, and it takes priority in repayment should you become unable to pay one or both mortgages.
Using your home as collateral is possible because your home is an asset. Such an asset can gain value – or decrease in value. Second mortgages provide a way of using your asset for other projects without selling the house.
This loan action is known as a second mortgage because of the order liens secure it as well as the order it is paid off. For instance, if you can’t afford to pay your mortgages, your home may be sold in order to pay your debts. In this scenario, the initial house loan is paid off first and the second mortgage is paid off afterwards. If selling the house doesn’t garner enough equity to pay both loans entirely, the second mortgage loan lender may not receive the full owed amount. Therefore, interest rates on second mortgage loans are typically higher than first mortgage loans.
The order that the loans are paid off means that a second mortgage increases the overall burden of your debt. Depending on your personal situation, this could be a negative thing because you are more vulnerable in case of financial difficulties that result in your inability to repay debts.
Second mortgages can be risky because if you can’t repay one, your home is the collateral – which means that you could lose your home.
Types of second mortgages
There are a few types of second mortgages:
- Home equity lines of credit (HELOCs) – this is a pool of money. You can draw money as you’d like, but you are not required to do so. It can function as a back-up for emergency funds if needed.
- Open-end mortgages – in this mortgage, you can continue to withdraw cash up to the maximum credit amount while drawing against up to the same limit as you continue to pay down the balance.
- Home equity loans – which are also known as lump sum mortgages or closed end mortgages. This is a one-time withdraw in which you receive the entire amount of the loan upfront. You are not able to redraw after that one-time withdraw.
Equity as a second mortgage
Second mortgages rely on the equity of your home. Equity is the market value of your home in relation to any outstanding loan balances. So, if your home is currently valued on the market at $300,000, but you owe $250,000 towards your first mortgage, your equity is $50,000.
Equity can grow or decrease over time, but ideally, it increases over time. Many things can have an impact – positive or negative – on your home’s equity:
- Making monthly payments on your mortgage. As your loan balance decreases, your equity increases.
- Improving your home. Make renovations that are worthwhile (improving kitchens, bathrooms, roofs, windows, etc.) are a way to proactively add value to your home.
- Changing real estate market. If your neighborhood or region is heating up on the real estate market, the value to your home can increase. Conversely, if the real estate market loses steam, your value could decrease.
- Borrowing against your home. Your equity will decrease as you borrow against its value.
Pros and cons of second mortgages
With many financial decisions, there are pros and cons that you must weight before reaching a decision.
Advantages of second mortgages can include:
- Borrowing significantly more than you may otherwise be able. Because you’re using the value of your home, you can borrow more than a more conventional method like a standard loan may allow. This means you may be able to finance larger projects or goals that are otherwise years in the future.
- Obtaining a lower interest rate. While other conventional loans, such as personal or car loans or credit cards, routinely feature double-digit interest rates, a second mortgage interest rate could be lower than those options because it is secured against the value of your home. Interest rates on your second mortgage are unlikely to be less than your initial mortgage, because the risk is still higher, even if it is a secured risk for the lender.
- Claiming tax benefits. This mostly applies to mortgages prior to 2018, but you may quality for a deduction for the interest you’ve paid towards a second mortgage.
Second mortgages, however, can be riskier than first mortgages. Here are some disadvantages of second mortgages:
- Risking foreclosure. A second mortgage means your house is on the line, so if you’re unable to make payments, your lender can foreclose on your house. Because it’s a second mortgage, the balance from a house sale would go to your initial mortgage first, with any remaining monies going towards your second mortgage. You are still responsible for any leftover balances.
- Spending money on up-front mortgage costs. When you mortgaged your home, you had to spend money covering fees, credit checks, appraisals, and other closing costs. And all those can still apply in this second mortgage.
- Spending money on interest costs. Despite its advantages, a second mortgage is still a loan – therefore you are spending money on interest, which can be a significant amount depending on the total amount of your second loan.
Reasons for obtaining a second mortgage
Your reason for obtaining a second mortgage can vary widely, but the general rule of thumb is to obtain a second mortgage for a project or goal that will improve your overall network – whether for yourself, your family, or your home – in the future. A second mortgage is too risky for people who are simply looking to consolidate costs or boost their living standard.
Here are common reasons people often obtain second mortgages:
- Education. If an education path or higher degree helps you obtain higher income, it may worth the investment now. Still, consider whether standard student loans are a better option.
- Home improvements. This is a popular reason for a second mortgage because you may be able to sell your home at a higher cost than without the improvements, which means you can more easily pay the outstanding loans. You’ll want to make sure the improvements are likely to increase your home value and not simply cosmetic or especially customized. Improved, modern kitchens and bathrooms are better investments than tearing down walls to make a bigger space or building an extra space that future buyers may not need.
- Investments. Some people use a second mortgage as a way to expand their real estate investments – perhaps in buying a second home or vacation property that can generate its own income.
- A way to avoid private mortgage insurance (PMI). PMI is an insurance fee on your first mortgage that may apply, so using a second mortgage can help keep your loan-to-value ratio high enough on your first mortgage to avoid the PMI. Make sure that it makes sense financially to take a second mortgage out instead of simply paying the built-in cost of your PMI.
Tips for securing a second mortgage
If you have decided that a second mortgage is the right option for you, here are some tips to consider when arranging one:
- Use home equity carefully, especially when consolidating higher interest debts. Paying off other debts is a good thing, but when you use home equity to do so, you aren’t truly paying off your debts. Instead, you are using one loan to pay for a second loan. Because your mortgaged house is your collateral, your interest rates for a second mortgage may be lower than on other debts. But, if you are unable to pay the second mortgage, you risk losing your house altogether.
- Know your reasons for a second mortgage. Because of the risks associated with it, a second mortgage should be used as a tool towards a larger goal. A second mortgage is not always a wise decision for consolidating or something to do simply because you can.
- Be prepared. Just as you did on your first mortgage, you’ll want to get your paperwork in order and ensure your money is sitting in the right accounts to access it when it’s time. It may be worth the cost to meet with a mortgage broker who can advise you through several financial options.
- Shop around for the best rates. Not all second mortgages are created equal, just like your first mortgage or other loans you’ve taken out. Consider a large, national bank as well as local banks and credit unions and mortgage brokers. Online lenders are become more prevalent, and they can often offer a lower rate in exchange for less presence.
- Understand the details of a contract. Some loans can have risky features such as balloon payments and prepayment penalties. Loans from upstanding places likely won’t have these features included, but if you’re considering a lower-interest rate loan, beware that these features may be included and could – in the long run – damage your plans for repayment or affect your credit line.
Defaulting on second mortgages
It may happen for a variety of reasons that you are no longer able to make payments on your second mortgage. In this scenario, your lender has the authority to foreclose on the house, whether it is a first or a second mortgage.
Your outcomes should you default will depend on whether your mortgage is “underwater”. If the value of your home is higher than the outstanding amount on your first mortgage, your second mortgage may be secured, at least partially. If, on the other hand, your home’s value is less than your mortgage debt, your mortgage is likely underwater.
If you have defaulted or are close to defaulting on a mortgage, whether it is your first or second mortgage, a foreclosure is not imperative, though it is possible. Many professionals will recommend focusing on paying your first mortgage, as defaulting on that can have more significant ramifications.
No matter your situation, seek out a professional legal team who are experts in this field. The right attorney is knowledgeable in both the financial and legal impacts of second mortgages. San Diego Bankruptcy Attorney has years of experience helping clients across the San Diego region explore second mortgages while understanding how these can positively and negatively affect their long-term financial health. If you’re considering a second mortgage or need to fight a legal case against you and your home, give us a call today at 619-488-6168 to learn how we can help you.