Second mortgage loans can be a great way to utilize the equity you have built in your home. A second mortgage loan is a loan that is secured by your home and falls “second” in line to the first mortgage. First, we will review the most common reasons for a second mortgage and then we will review the financing options available.
Reasons for a Second Mortgage
The most common reasons for a second mortgage are:
• Debt consolidation
• Paying college tuition
• Home improvements
• To avoid PMI
Debt Consolidation Of course, those are serious consequences. But when you roll the debt into a second mortgage, the lender can foreclose on your home.
Many people seek a second mortgage for debt consolidation. But think long and hard before you go down that road. In many instances, the debt you wish to consolidate is from credit cards, which is unsecured. If you do not make payments on a credit card, the worst thing that can happen is your credit rating is ruined and you have debt collectors harassing you.
For those who are consolidating debt and have made lifestyle changes to ensure they do not end up in the same situation again, a second mortgage can be a good option. The rates are usually lower than most credit card interest rates and the interest is typically tax-deductible.
Paying For College Tuition
In the case of paying for college tuition, a second mortgage loan can be an excellent option. Because the second mortgage is tied to your home, you can reap the tax deduction at year-end from the interest. But once again, you are using your home as collateral, which puts it at risk if for some reason you cannot make the payments.
Keep in mind, there are federal loan programs as well that may offer lower interest rates. These loans are often unsecured meaning you are not putting your house on the line so your child can pursue a college education.
In this case, home improvements can increase the value of your home and therefore your equity. The second mortgage loan can allow you to borrow funds to improve your home at low interest rates compared to visiting a home improvement store every weekend and charging the purchases to your credit card. Again, the interest is usually tax-deductible.
To Avoid PMI
Some borrowers, who do not have a 20% down payment, take out a second mortgage at the same time as their first mortgage. This second mortgage is for the 20% down payment and enables the borrower to avoid paying PMI (Private Mortgage Insurance). This loan is also referred to as a piggyback loan.
In some cases, borrowers have been known to attach their home to purchases such as a car in order to obtain the tax benefit. In this case, the interest paid on the car would qualify as mortgage interest for tax purposes since the home is also used as collateral on the loan.
Second Mortgage Financing Options
So you have made the decision to use the equity in your home. You may think the decision-making is over, but it is only beginning. There are several options available to you including the fixed rate second mortgage loan, the home equity line of credit and the multiple line HELOC.
Fixed Rate Second Mortgage
This is also referred to as a home equity loan. This loan is taken out for a certain amount and all funds are distributed at the inception of the loan. The interest rate and payment scheduled is fixed for the life of the loan. This is a good option for those who are making a one-time purchase. These loans can range from one year to twenty years depending on the amount of money borrowed.
Home Equity Line of Credit
A home equity line of credit, also referred to as a HELOC, is similar to a credit card. The line is set at a fixed amount and the borrower has the option to borrow up to that amount, pay it down, borrow again, etc. This loan is a much more flexible option than the fixed rate second mortgage loan.
The HELOC features a variable interest rate that is generally tied to the Wall Street Journal Prime (WSJP) rate. When the WSJP increases or decreases, the rate on the HELOC follows suit. The repayment on this loan can vary from lender to lender. Generally a certain percentage of principal plus all interest is due each month. For example, 1.5% principal payment plus interest due. Because the payment is based on the amount that is outstanding on the loan and the interest rate is subject to change, payments over the life of a HELOC can vary dramatically. Interest only HELOCs are also available.
Many banks offer no closing costs on HELOCs if the line is drawn immediately and stays above a specified amount for the first six months. For instance, on a $20,000 HELOC, if you draw $10,000 and maintain that balance for six months, all closing costs are waived.
At the end of the loan term, refinancing or repayment of the HELOC is expected. This can present a problem for a borrower who is unable to obtain financing. At this point, the home could be at risk for foreclosure.
Multiple Line HELOC
Some lenders are now offering a multiple line HELOC. In this instance, the lender sets up multiple lines the borrower can use. For instance, a $50,000 multiple line HELOC may look like this:
• $10,000 interest only payment
• $20,000 fixed payment amount
• $20,000 variable payment amount
This type of arrangement is usually reserved for borrowers with an excellent credit history. The advantage of this arrangement is the borrower does not have to visit the bank to apply for a new loan each time they make a purchase. For instance, this would allow the borrower to buy a car without ever visiting with their lender. This loan gives the borrower the ultimate in flexibility when making purchases.
As you can see, second mortgage loans can be an excellent financing option for homeowners. Whether you choose a fixed rate home equity loan or a HELOC, remember your home is on the line. Be sure to explore all of your options and use your lender as a resource for information. Your equity is a great asset that should be used carefully.