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How Second Mortgages Work

What is a Second Home Mortgage?

A second home mortgage is exactly like the first in every way except in terms of which comes first as a priority. If for example, you default on your home, the proceeds of the sale would have to go to the first mortgage until such a time money is available to pay for the second mortgage.

There are two types of second mortgages to choose from, and each has its own pros and cons for homeowners with different financial situations. The two types of second mortgages are home equity lines of credit (HELOC) and home equity loans.

For more detailed information on the differences between HELOCs and home equity loans, click here.

Requirements for a Second Home Mortgage

The higher your home equity, credit score, and income, the more eligible for a bigger home equity loan or HELOC you'll be. The size of a home equity loan, for example, largely depends on how much equity you have. Let's see this in action:

  • Good home equity: Home equity is basically the difference between your home's initial appraised value and the size of the first mortgage. If for instance, your house's market value was $500,000 and you put down $100,000 (20%) for a mortgage loan, your home's new market value works out to be $400,000. Your loan-to-value (LTV) ratio is the appraised home value ÷ size of the mortgage = 400,000 ÷ 500,000 = 0.8, or 80%. Which is the maximum LTV most lenders will gamble with unless you're willing to pay for private mortgage insurance (PMI) and higher interest rates. The same holds true with the second mortgage. If you can keep the LTV of your combined mortgages 80% and under, you're in the safe zone with access to more affordable loan services.
  • Good credit score: Bad credit scores means high-risk borrowers for banks and lenders. Make sure you don't have excessive debt and unpaid fees on your balance sheet. 
  • Sufficient income: Your lender needs to know that you have the income to cover the extra monthly charges or the extra closing costs on the loan, depending on the kind of second mortgage you get (discussed further down).
  • A home appraisal: If your lender does not provide you with a professional appraiser, you can simply hire your own although this could be costly. Some lenders require select appraisers to do the job in order for you to be eligible.

The Differences Between Home Equity Lines of Credit (HELOCs) and Home Equity Loans

Theoretically, HELOCs and home equity loans can bare the same expenses on a homeowner but there are case-specific loopholes that informed borrowers can take advantage of in practice. The loopholes are the differences between the two and what those differences mean in terms of your financial situation.

Type of Loan Description
HELOCs

 Home equity lines of credit (HELOC) are converted from your home equity into credit. Just like a credit card. The size of your home equity is your credit balance and you can withdraw credit for whatever purpose, whenever you need it.

 - Can be used whenever it's needed (like a credit card).

 - Credit can be withdrawn in small or big increments.

 - Form of repayment: Paid in slightly varied monthly installments for the duration of the loan.

 - Reasons for loan: 

  • Small-time home remodeling
  • School tuition
  • Taking care of smaller debts
  • Vacationing.

 - APR: Higher interest rates.

 - Type of interest: *Adjustable rate.

 - Tax deductibility: Interest is tax deductible.

Home Equity Loans

 A home equity loan is given to you by the lender in the form of a lump-sum.

 - A one-time-only transaction.

 - Lump-sum.

 - Form of repayment: 

  • Paid in fixed monthly installments
  • Closing costs are typical between 3 - 6%.

 - Reasons for loan:

  • Major home remodeling projects
  • A new home
  • College tuition
  • Weddings
  • Paying off significantly high debts.

 - APR: Lower interest rates.

 - Type of interest: **Fixed-rate.

 - Tax deductibility: Interest is not always tax deductible.

 

*Adjustable-rate mortgages (ARMs) are characterized by interest rates that are able to fluctuate over the life of the loan, depending on the index to which they're assigned. There are, of course, "caps" that limit how extreme those fluctuations can get. The good thing about ARMs is that they have many variants to choose from that differ in the lengths of time interest rates remain fixed throughout the loan's life.

**Fixed-rate mortgages (FRMs) are the predictable and simple choice. They usually have slightly higher interest rates than ARMs but can be more stable and reliable. In times of extremely high-interest rates, your monthly payments remain the same for the entire life of the loan.

Disadvantages of a Second Mortgage

  • Excessive debt for most homeowners.
  • High interest rates are likely for most homeowners.
  • Will immediately reduce the home equity you've built over the years.
  • A high-risk transaction for lenders and banks.

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