Second mortgages were quite popular around 2006 before the subsequent housing bust gave them a bad name. However, they do have a place in responsible borrowing, and a slowly improving housing market in 2014 is driving renewed interest in these loans.
A second mortgage is just what the name implies – a second loan against your home. There are two basic types of second mortgage:
- Home Equity Loan – This is essentially a traditional loan that is subservient to the first loan. Since the first loan takes precedence in case of default, the interest rates will be higher compared to a first mortgage.
- Home Equity Line of Credit (HELOC) – These are more analogous to a credit card backed by the equity in your home. HELOC's do not have a set term, and interest rates will vary.
As to whether a second mortgage is right for you, it depends mostly on what you want to use it for, and whether or not it could jeopardize your overall ability to repay. Consider these uses for second mortgages:
- Piggybacking – This term refers to avoiding PMI (Private Mortgage Insurance) on a loan by financing all or part of your down payment money with a second loan.
Prior to the housing bust, it was possible to finance 80% of a home on the first mortgage, and take out the typical 20% required down payment under a second mortgage. You could literally purchase a house on 100% debt. Those days are effectively over, but it is still possible to finance half of your down payment with an 80/10/10 loan (80% first mortgage, 10% second mortgage, 10% down payment) and avoid PMI.
- Home improvements – Taking out a second mortgage for home improvements is one of the best uses of a home equity loan or HELOC. Home additions and other improvement projects are likely to increase the value of your home, giving you a decent return for your risk (and if it doesn't improve the value of your home, should you be doing it at all?).
- Debt Consolidation – Paying off high interest credit card debt and replacing it with a lower interest rate second mortgage sounds good on the surface, but may actually be a poor idea. Why?
For starters, you are replacing unsecured debt with secured debt, which is less than ideal. More importantly, if you racked up credit card debt, what is to stop you from doing it again? You are likely to be in the same place you were, with the added danger of losing your home.
This could make sense in rare circumstances such as a large, one-off medical bill, but in almost all cases, there is a better path than a second mortgage.
- Educational Expenses – College tuition can be crushing, and a second mortgage can spread that burden out. However, this should be far down on the priority list of educational options. There are many scholarship opportunities and aid programs that can help you to finance higher education without risking your home.
- Investment – Acquiring cash on a second mortgage to use it for another investment, such as acquiring start-up funds for a business, is risky – but only you can decide if the risk is acceptable. You must have confidence in your ability to earn a higher return from your investment strategy, less the after-tax debt service cost of your second mortgage.
Are you ready to ride the next wave of second mortgages? After reading this article, perhaps you are… or perhaps you have thought better of it. In either case, as long as you have done your research you should feel comfortable with your decision. If you aren't comfortable, seek a professional opinion. But no matter what advice you get, remember that it is your house that you are putting at risk.