The 2nd mortgage is a useful tool that can greatly extend the financial options of a person with equity in a piece of real estate. However, the responsibilities of this kind of a loan are equally as large. You must understand the risks and the advantages of the 2nd mortgage fully before committing yourself to it. Here are some answers to top questions that you should be asking.
1. What is a 2nd mortgage?
A 2nd mortgage is defined as a mortgage that is taken out on a piece of real estate that already has a mortgage on it. Borrowers will often use the equity in the home as a low interest bank to finance improvements in the home or in other aspects of their lives.
2. How do I know if I need a 2nd mortgage?
Vetting yourself for a 2nd mortgage is a complicated process that involves weighing the costs of the mortgage against the benefits that you hope to receive from the extra cash or cash flow. In general, you should only use a 2nd mortgage option to pay for things that will build value in the future.
3. What are the different types of 2nd mortgages?
There are two major types of 2nd mortgage: the cash out option and the home equity line of credit (HELOC) option. The cash out option gives you a lump sum that you can use as you see fit. The HELOC option is more like a line of credit from a credit card. You will actually receive a special credit card that you can use in a normal fashion for your purchases.
4. How do I know to use a cash out or HELOCÂ plan?
If you need a large amount of money quickly, the cash out option gives you a set value that you can pay back on a fixed interest rate. HELOC balances change daily with the market value of the home, meaning that the interest that you pay depends on the time at which you take out money and the market value of your property. A HELOC is more like an adjustable interest rate loan that is more usable over small expenses and longer time frames.
5. Should I take out a 2nd mortgage or borrow from a 401k in retirement?
Determine the draw that will give you the lowest after tax cost as your metric here. After tax cost is calculated as (1 – your interest rate – tax savings). In the case of the 401k, your cost is mostly an economic opportunity cost, because you are losing the interest that you would have earned by leaving the money in the account.
If you earn more in interest from your 401k than you give back in your HELOC, then take from the HELOC. There is an additional tax benefit to taking from a HELOC, because taking from a 401k will eventually cause a tax liability.
6. Can I pay off my 1st mortgage with my 2nd mortgage?
A 2nd mortgage is always considered a higher risk than a first mortgage, but you very well might be able to get a 2nd mortgage with an adjustable interest rate that is lower than the fixed rate on your first mortgage. However, you should only try this if you have a relatively small balance on your primary mortgage that you can quickly pay off. This reduces the risk of the market taking your adjustable rate through the stratosphere.
If you have a high fixed interest rate on your primary mortgage, you may also be able to refinance at a lower fixed interest rate today. This is a much less risky proposition.
7. Can I combine the 1st and 2nd mortgage interest rates?
You can use a blended rate to sometimes reduce the amount of your monthly payments, as well as your total interest rate. However, when you calculate your true payments, make sure that you include your upfront costs and the time value of your money to get a true blended rate and not just a weighted average.
8. Is there a difference between a 2nd mortgage and a home equity loan?
This terminology can get confusing, because the home equity loan or HELOC is often used as a synonym for a 2nd mortgage. However, a HELOC can be a first mortgage as well.
9. Can I refinance a fixed rate mortgage into a HELOC?
Refinancing into an adjustable rate is always risky, and should only be done if you expect to be out of the property within five or so years.
10. What is a combination loan?
A combination loan involves taking out two loans at once on a property to avoid PMI payments and stay under conforming loan limits.
11. How do I qualify for a 2nd mortgage?
A 2nd mortgages is often more contingent on the equity that you currently hold in your property than on your credit score or financial history. You should also maintain a good record of paying on the first mortgage.
12. Can I take out a 2nd mortgage to stay within conforming loan limits?
Many borrowers use two mortgages to stay under conforming loan limits and avoid the higher interest payments and increased scrutiny that come with jumbo loans. However, make sure that you factor in the increased origination costs of the two mortgages and use a blended rate, not a simple weighted average, when you run your comparison costs on paying for a jumbo loan or splitting the mortgage into two parts.
2 Point Highlight
In general, you should only use a 2nd mortgage option to pay for things that will build value in the future, not for consumer items or short term purchases.
A combination loan involves taking out two loans at once on a property to avoid PMI payments and stay under conforming loan limits.
