The Many Pragmatic Uses Of A Second Mortgage

A second mortgage basically refers to a loan with a second-priority lien on a property after another mortgage.

A first mortgage typically uses the property as collateral for the bulk of the borrowed funds to finance the purchase of it.

When a second mortgage comes into the picture, it is usually due to some form of seller financing or any type of credit facilities involving home equity.

Home equity and second mortgages

Other than a regular home loan, there are basically 2 most common types of credit facilities involving home equity.

  1. Home equity loan
  2. Home equity line of credit, HELOC for short

A home equity loan is a term loan whereby the borrower draws out a lump sum in cash, then repays it by installments like the first mortgage.

They can structured as fixed rate or adjustable rate loans.

A borrower intending to raise cash should weigh up the pros and cons of a cash out refi against that of a home equity loan.

A HELOC is a line of credit, sort of like an overdraft account and allows the borrower to draw funds from as and when it is needed. It will of course come with limits.

They primarily come with adjustable rates.

When the line of credit is not used, the homeowner basically don’t pay any interest. But might have to pay an annual facility fee to keep the credit line active.

A home equity loan would be more suitable for a borrower if a huge sum of money is required at a moment in time. Like for investments or business use.

A HELOC would be more suitable for those who want a backup of funds should the need for it arise in the future. It would also fit nicely into a financial plan that requires cash over a stretched out period of time.

Both of them can be refinanced when the need arises.

However, refinancing will require the new lender to assess the mortgage like any new loan.

A bigger challenge is that a second mortgage decreases the amount of equity in a house. Sometimes even taking a house from one with positive equity to negative equity.

When this happens, traditional lenders wouldn’t touch the deal with a fishing pole.

Second mortgage usually pricier than first

It must also be said that a second mortgage will inevitably be more expensive compared to the first.

This is because it inherently carries more risks.

Should a default occur, the first lender with the first lien will have first-priority claim for the balance amount owed. The second lender will only be left with the scraps (if there’s anything left) after the first has had it’s share.

It would be like being in the queue at the tickets office for hot concert that is selling out fast. You don’t know if there would be any tickets left by the time your turn arrives. And even if there is, will there be any good seats left.

The higher risks involved translates to a higher interest rate.

However, in certain circumstances when the second mortgage is a HELOC with adjustable interest rates, market forces might push it below the rate of the first.

Even so, closing costs for settlement might still make it too expensive.

Using a second to pay off a first

It is generally not a smart move to refinance a first loan with a second.

This is because second loans tend to be pricier than the first as mentioned earlier.

Moreover, making such a move pays off the first, which effectively moves the second to the first.

Bearing in mind second loans are more expensive, it can seem odd to pay those high rates for a loan that eventually becomes the first in line.

But we live in a dynamic world where unique opportunities and circumstances can arise that makes it worthwhile.

Sometimes the interest rates for HELOCs make it attractive to use one to refinance the first.

While this can seem like a pragmatic move, be mindful that HELOCs carries very high exposure to adjustable rates.

Second loans and mortgage insurance

Lenders require home buyers who put down less than 20% as down payment are required to purchase private mortgage insurance, the idea of exploiting a second mortgage to navigate around this rule was conceptualized.

For example, a property buyer can take up 80% loan to value with the first loan, then use a second loan to take up 5%.

This practice effectively makes it possible to avoid spending more money on mortgage insurance premiums.

Combination loans, a type of piggy back mortgages, that does this are referred to as:

  • 80-5-15
  • 80-10-10
  • 80-15-5

80-5-15 for example, means that there is a break down of 80% first, 5% second, and 15% down payment.

However, whether combination loans do save a borrower money depends on many factors.

Do work out the numbers before getting into such programs.

Jumbo loans

When the loan size required by a borrower exceeds the limits of conforming mortgages, a borrower might have to take up a jumbo mortgage which comes with higher interest rates.

Depending on circumstances, it might be more financially savvy to obtain a loan at the maximum limit, and use a second loan to make up the excess.

The problem again is closing costs as the borrower will now be signing up for two loans instead of one.

Again, this should be undertaken after careful review of the numbers involved.

But do note that should you use two loans instead of one, you can’t refinance just the first one without the second.

The first and second has to be refinanced together as a whole unless the second lien owner expressly agrees to be excluded by signing a subordination agreement.

With all that said, even though second mortgages tend to be more expensive than the first, there are various circumstances that make signing up for one a shrewd move.

It must be mentioned however, that as a second mortgage is also a secured loan, interest rates tend to be lower compared to other credit products on the market.