How Do Second Mortgages Work?

Feb 05, 2017 by Amy Orr

Second Mortgages Personal Loans Mortgages

Second Mortgages in Canada

Anyone who has bought a home knows the complicated process of getting a home mortgage to finance the purchase. Assuming all has gone as planned, the homeowner has been living peacefully in the house, making payments on time and building equity. These scenarios are suited for second mortgages, if the homeowner decides the time is right.

Just like the first mortgage, a second mortgage is secured by the home. The amount of the mortgage depends on how much equity there is in the home and other factors. The consequences of default are the same as well; nonpayment of second mortgages result in foreclosure and sale of the home. The original mortgage is paid first with the proceeds, with the second mortgage next in line.

Second mortgages on current homes have increased over the last few years for several reasons, like lower interest rates and increased home values. But homeowners are also purchasing second homes in addition to their residence for some of these same reasons.

This article will cover these topics:

Why second mortgages are so popular
Variety of second mortgage products
Cautionary tips about second mortgages
How much can a homeowner borrow?
Second mortgages to buy another property

Why Second Mortgages are So Popular

The main appeal of second mortgages is that the interest rates are low as home values rise. This means that money is available in equity plus the home is worth more. For many homeowners, it means more money in their pocket for less cost. Second mortgages often provide tax advantages to the homeowner. Second mortgages are also preferred because homeowners have a choice of how to spend the proceeds. Ideally, the homeowner will re-invest in the home to improve its future value if they sell later.

However, second mortgages can also be used for:

Debt consolidation of other credit such as credit cards, personal loans, and revolving credit.
Rather than utilize the somewhat safer student loan options, some homeowners use second mortgages to pay for educational expenses for themselves or family members.
More than a few homeowners have taken out second mortgages to cover medical expenses which are not covered by insurance.
Some homeowners have made the financially risky move to take out a second mortgage to start a business or help finance a business for a friend or family member.

Although there are very few restrictions on the use of proceeds of a second mortgage, experts advise homeowners to choose how they spend the funds carefully. It may be fun to go on a nice vacation or get new clothes and jewelry, but the homeowner must remember that their home is at risk if the mortgage is not repaid.

Variety of Second Mortgage Products

There are two primary types of home mortgage products. As noted, each of these are borrowed against the equity in the home. They are a home equity loan and a home equity line of credit. The features of each type are:

Home Equity Loan

With a home equity loan, the borrower gets a certain amount of money in one lump sum. The payments on the loan are paid monthly for a set period of time. The payments include the principal amount of the loan plus interest. Once it is paid off, the home equity loan contract is complete and the lender removes the lien interest on that amount from the home. It is common for home equity loans to come with fixed interest rates.

Home Equity Line of Credit

A home equity line of credit (also known as HELOC) is a revolving amount of credit that is issued for the homeowner to borrow against as needed. The maximum limit is set by the lender, like a credit card. The borrower can use as much or little as needed, the money paid can be reused. HELOC’s very often come with an adjustable interest rate.

Cautionary Tips about Second Mortgages

It is understood that with any type of secured loan, like auto loans and mortgages, collateral security is put in place to guarantee repayment. Second mortgages also put the home at risk if left unpaid.

Other reasons to carefully consider a second mortgage include:

There are fees, such as closing costs and appraisals, that can be expensive.
If the homeowner’s credit score is lower than when the first mortgage was approved, the interest rate will probably be higher.
Home equity lines of credit interest rates are variable, which means they can cost a lot more money when the market rises.
Depending on the homeowner’s location and circumstances, there may not be tax advantages which will benefit the homeowner (homeowners must consult with a tax adviser before applying).
Homeowners should not assume they have to get a second mortgage from the same lender as the first; they should shop around to find lower interest rates with another lender.
The borrower should make sure the second mortgage does not include balloon payments, prepayment penalties, duplicate insurance or other undesirable features.

How Much Can a Homeowner Borrow?

A homeowner should not assume they can borrow the exact amount of equity they have in the home, although this is a consideration for second mortgages. Other factors that may weigh in on the approval are:

The loan-to-ratio value (the percentage of property mortgaged)
Current credit score
The value of the home

Since the home is the security for the loan, it is possible to borrow against the worth of the home, which is more money than the equity. Some lenders allow homeowners to borrow up to 80% of the home’s value, (meaning the total of both the first and second mortgage).

Second Mortgages to Buy Another Property

Thus far, this article covered second mortgages on existing residences. But some homeowners find themselves in the position to purchase a second home such as a vacation home, rental property or other use. This can also be referred to as a second mortgage. However, the process of buying a second home is typically unlike the purchase of the primary residence.

A few problems with second mortgage financing are:

Most lenders require a substantial down payment for purchase of a second home.
Lenders expect a higher credit score for second mortgages than their first home purchase to be sure the borrower can afford another home.
Borrowers are expected to have a large amount in liquid reserves such as cash or other assets. Some lenders require borrowers to have on hand as much as 6 months’ worth of mortgage payments on both mortgages.
The debt-to-income ratio is much stricter on borrowers who want to buy a second home.

Second mortgages on a primary residence is just one of the benefits of home ownership. If used properly, it can be a way to draw on the equity of the home for a useful or necessary purpose. Homeowners who can afford to buy a second home for reasons of their own choosing can also take advantage of the benefits second mortgages offer. With pre-planning and accurate information, second mortgages can be a sound financial decision.

Amy Orr

Amy Orr is a professional writer and editor with over 10 years of experience in the Canadian, U.S. and U.K. financial markets. She has written for numerous publications on topics as diverse as economic literacy, corporate finance, and technical analysis of numerical data. Prior to transitioning to full-time writing, she worked in the hedge fund sector. Her academic background is astrophysics, and she has a Masters in Finance from the University of Edinburgh Business School.