Maybe this has happened to you.
You’ve been steadily paying off your mortgage when suddenly, you start getting letters from lenders inviting you to take out a second mortgage. "Build wealth!" they say. "Pay for your education! Renovate your house!"
The promises are tempting, the interest rates are competitive, and the money seems legitimate. It can’t be too risky, right?
Hold up! Before you get yourself in another mortgage bind, let’s take a closer look at second mortgages.
What is a second mortgage?
As grueling as it sounds, to really understand what a second mortgage is, we have to take a step back and remember how home equity works.
What is home equity?
Unless you’ve paid off your mortgage, you don’t technically own your whole house. You own a portion equal to the amount you’ve paid. Home equity is that portion of your house that’s truly yours. It’s pretty simple to calculate: Just subtract your mortgage balance from the market value of your home.
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For example, say your home was valued at $250,000 the last time you checked, and you owe $150,000 on your mortgage. To figure your equity, you’d just subtract $150,000 from $250,000. That means your home equity would equal $100,000, but that’s assuming the market value of your home has stayed the same. More often than not, the market value fluctuates, so your equity will too, depending on which way the market blows.
How did home equity create the second mortgage?
Well, here’s what happened. Some homeowners got to thinking and said, "You know what? I have $100,000 in equity. Why can’t I turn that $100,000 into money I can use to pay off my student loans, renovate my house, or go on vacation?"
Low and behold, some lenders thought that was a great idea and replied, "You’ve got yourself a deal!" The lenders agreed to give the homeowners their equity if the homeowners promised to pay them back with interest—or hand over their house if they didn’t.
And voilà! Just like that, the second mortgage was born.
What exactly is a second mortgage?
With a second mortgage, you borrow your equity in order to pay off other debts, complete home improvement projects, or buy something you couldn’t otherwise afford. But it’s debt. You must pay it back. And since a second mortgage is secured by your home, you’ll lose your house if you don’t pay it back. That’s some scary stuff.
What are the types of second mortgages?
Let’s look at two forms of second mortgages. With these two, you can choose to take your money as a lump sum in a home equity loan, or you can draw from a credit line, called a Home Equity Line of Credit.
Home Equity Loans
With a home equity loan, your lender gives you a stack of money based on your equity, and you repay the lender every month. Because it’s a one-time lump sum, home equity loans come with a fixed interest rate, so monthly payments don’t change.
Home Equity Line of Credit (HELOC)
With a HELOC, your lender pre-approves you to borrow a large amount of your equity—but not as a lump sum. Instead, you just withdraw what you need. Like a credit card, you have a borrowing limit, and you only pay for the amount you borrow.
Unlike a plain old home equity loan, a HELOC is a revolving credit line: You can borrow money, pay it off, and use it again. You do, however, have a borrowing time frame, and once that time has ended, you must pay off your account—or your lender will take your house.
What’s required to get a second mortgage?
Equity. And lots of it. Second mortgages are risky for lenders because if your home is foreclosed, the lender of your first mortgage gets dibs on your house. So, when it comes to issuing second mortgages, lenders want to know three things.
1. You have good credit. If you’ve had trouble paying off your first mortgage, good luck getting a second one. You must prove to your lender that you consistently pay your mortgage payments; otherwise, they won’t consider your application.
2. You have equity. In most cases, lenders want an appraiser to look at your house and calculate your equity. While you can get a rough estimate based on how much mortgage remains and how many payments you’ve made, an appraiser will take a closer look at the market value of your home to give an accurate number.
3. You don’t have a lot of debt. Just like when you applied for your first mortgage, lenders want to know you have a steady income and you’re not up to your neck in debt. Your lender will want to review your pay stubs, tax returns, and bank statements.
Why do people get second mortgages?
Homeowners are tempted to get second mortgages for three main reasons.
1. To pay off another loan or debt.
Can you use a loan to pay off a loan? Yep. (Do we recommend doing this? Nope.) Many people use their second mortgage to pay off student loans, credit cards, medical debt, or even to pay off a portion of their first mortgage.
2. To fund home improvement projects.
Can’t wait to add the backsplash in the kitchen? Always wanted a swimming pool but never had the cash? Homeowners sometimes take out a second mortgage to renovate their houses. The idea is that if you renovate your house, you’ll increase the market value of your home, getting you more equity. But that idea assumes the market value of your home will go up. However, if the value of the homes in your area goes down, you’d have a major problem—and no equity.
3. To make a personal purchase—a big one.
Though this isn’t as common as the first two, people will take out a second mortgage to buy a new car or fund an exotic vacation. But don’t fall for this! It’s just a trap for more debt.
Here’s the truth about second mortgages.
Second mortgages are tempting. The way lenders package them, they may even seem like a gift. But take away the inflated promises and enticing interest rates, and you’ll see them for what they really are: debt repackaged as debt.
If you’re considering a second mortgage, here are three reasons why you should avoid them at all costs.
1. Second mortgages put your home at risk.
Your lender may act friendly when you’re applying, but miss a payment, and they won’t hesitate to take your home. Is that new backsplash in your kitchen really worth the risk of losing your house? No! It’s just a backsplash! If you can’t afford the renovation, then don’t do it.
Renovating your property to increase your home’s value is a great idea. But there are better ways of doing it than risking foreclosure. Save, save, save! There’s no better way than paying cash.
2. Second mortgages can’t turn equity into cash.
They turn equity into debt. Despite the freedom a second mortgage seems to give you, you must pay that money back. Second mortgages put you and your family farther into the hole of debt. And no matter how low the interest may seem, you’ll end up paying more in the long run.
3. Second mortgages put a strain on your income.
By taking out a second mortgage, you become more vulnerable to a financial crisis. You may be able to make the payments now, but if you lose your job or end up with a large medical bill, you could easily find yourself buried under too much debt.
You may see low interest rates and think you can’t pass up a deal like that. But when you add up all the costs—appraisal fees, application costs, closing costs—you’re not saving money.
If a second mortgage is debt, what Baby Step should you pay it off in?
If you took out a second mortgage but now you’re following Dave’s 7 Baby Steps, you might wonder at what point you should pay it off. Should you count it in your debt snowball and pay it off in Baby Step 2? Or should you refinance it into your first mortgage and pay it in Baby Step 6?
If your second mortgage is less than half your annual income, treat it as debt and pay if off in Baby Step 2. Don’t refinance it. Paying it off isn’t unreasonable—so long as you make it a goal and stay focused.
However, if your second mortgage is more than half your annual income, refinance it as part of your first mortgage and pay it off in Baby Step 6. Take care of your smaller debts and work your way to paying off the larger debt.
Need help with a mortgage?
Before you make any decision that will impact your future, seek out the qualified assistance of someone who knows the ins and outs of mortgages. Whatever your finances look like, our friends at Churchill Mortgage will equip you with the information you need to make the right decision.
The financial experts at Churchill Mortgage have helped hundreds of thousands of people plan smarter and live better. Talk with an expert at Churchill Mortgage today to help you find the right answers for your specific situation.