Your ’70s bathroom seemed amazing and hip when you bought the house. However, now that the novelty has worn thin, the orange vanity needs to go, along with the black toilet and bathtub. You can’t wait to shower in a spa-like setting with clean tiles and a double sink to save your marriage. However, you don’t have the funds readily available right now for a big renovation. So, how can you find the money to do this life-changing home improvement?
One popular option for financing home renovations and other expensive lifestyle needs is called a second mortgage. But you need to know all the ins and outs before taking on another loan because you could be signing up for a house-poor future, or even foreclosure.
What’s a second mortgage?
A second mortgage is essentially what it sounds like: it’s a second secured loan that you can take out as a homeowner, using your house as the collateral for the loan.
“People usually set up a home equity line of credit or get a second mortgage, so they can make improvements on their home or pay off bills,” says Richard Monley, Vice President Western Region Sales Manager at Hawthorn Bank in Lee’s Summit, Missouri. He also serves as president of Mortgage Bankers Association of Greater Kansas City.
A second mortgage can help you put a swimming pool in your backyard, add some extra square footage to your home, to pay off debt, or a number of other options. Although the money is loaned using your home as collateral, you have no obligation to spend it on the house.
“Most second mortgages offer shorter loan terms, usually 10 or 15 years,” Monley adds.
He explains that the interest rate can be fixed, or it can be adjustable. Adjustable rates typically start out lower than fixed rates, but will go up after a certain period of time. Rates on second mortgages also normally start higher than a first mortgage rate, partially because the lender will not earn as much interest income over the shorter-term life of the loan, but primarily because there is higher risk attached to a second mortgage.
As its name indicates, the second mortgage is in a secondary lien position behind your primary, or “first mortgage.” That means that if you were to default on your mortgage and your home goes into foreclosure, your first mortgage gets paid from the foreclosure sale first, and the second mortgage only gets paid off if there are sufficient proceeds remaining from the sale after the first mortgage is paid.
Some of the other reasons people get a second mortgage is to “fund a large purchase such as a car or even pay college tuition,” Monley says.
Just remember that if you take on a second mortgage, it’s a second loan using your home as collateral, or security, for the loan. This second loan is allowed when you have built equity in your property, and lenders determine how much to loan based on the equity you’ve built and the fair-market value of your house.
All that said, if circumstances change and you can’t pay that new loan, you could put yourself at risk of foreclosure and losing your house.
When can you get a second mortgage?
There are two scenarios where you can get a second mortgage, one as a homeowner and one as a homebuyer.
1. When you already own a home, you can leverage its equity with a second mortgage
Basically, you borrow against the value you already own in the home. More on this and how equity works a bit later.
2. When you’re buying a home, you can use a piggyback second mortgage loan to make a larger down payment
These are used to help you make a larger down payment and avoid mortgage insurance. This is also an equity loan, but it’s taken out when you buy your home rather than after you’re a homeowner.
The two main second mortgage choices for accessing equity
When looking for a second mortgage to access equity in the home you own, the two most popular options are a home equity loan or a home equity line of credit (HELOC).
Home equity loan
With a home equity loan, you’re taking out a specific total loan amount based on the amount of equity you’ve built in your property. A home equity loan is issued to the homeowner in one lump sum, which homeowners typically pay back at a contracted rate of interest, similar to the repayment on a standard first mortgage loan.
Home equity line of credit
Instead of getting a lump sum payment, with a home equity line of credit, a lender sets a borrowing limit for you based on how much equity is in your home and you can draw the funds as you need them. You won’t get the money until you request it, though.
Taking out a second mortgage on a home you own
If you’ve already owned your home for a while, you can take out a chunk of money from its equity to do whatever you need to do in your life.
You begin building equity in your home when you take out your first mortgage.
When you buy a house, unless you’re getting a loan with 0% down (which you can do under certain government-backed programs, such as VA and USDA loans), you had to bring some money to the table — a down payment. So when the home first transfers ownership from the seller to you, your equity in the home is equal to the down payment amount.
For example, if you’re buying a home for $300,000 and put down $15,000, then you have 5% equity in the house, and you owe your mortgage lender $285,000, or 95% of the home’s value.
How do you build home equity?
Building home equity happens organically as you own your home in two fundamental ways.
Making mortgage payments
Monley suggests that homeowners pay more than the minimum payment each month toward the principal balance on their mortgages. As you make mortgage payments and pay down your principal, your equity increases, and the amount of money you owe the lender decreases, so you can build equity by paying off your mortgage faster.
If you bought your house for $300,000, then for every $3,000 you pay toward your loan principal balance, you will gain 1% equity in your home … assuming home values remain stable.
Your home’s value increases
Another way to build equity is out of the homeowner’s control because it involves the real estate market. As your home’s value increases, you will accrue more equity in the property because it’s worth more than it was when you bought it, and that additional value “belongs” to you as the homeowner.
For example, let’s say the home you bought for $300,000 with $15,000 (5%) down has increased in value by $30,000 during the first five years you’ve owned it, and you’ve also managed to pay off $15,000 of your loan’s principal balance.
Between the $15,000 down payment and the $15,000 loan payoff, you now have accrued 10% in loan equity through your own efforts. And because home values have also increased by $30,000 (10%) in that time, you actually have a full 20% equity in your home now because you also “own” the increase in property value.
Mortgaging your earned equity
Once you’ve built equity in your home, you can use a second mortgage to “liquidate” that equity (an investor’s word for “turning your equity into cash”) so that you can spend it. Second mortgages are a way for you to tap into your investment without having to sell your home.
Remember, you can only get a second mortgage for the amount of equity you have in your home — you won’t be able to get a second mortgage for more than the value of your home’s equity.
And understand that you won’t necessarily be able to borrow all your equity, either. The amount you borrow is usually limited to between 80% and 85% of your equity in the property’s current market value, minus any money you still owe on your first mortgage.
Rates and terms
Rates and terms refer to the specifics of your second mortgage — how much interest you’ll pay and how long it will take you to pay back the loan.
Your second mortgage’s interest rate will be based on your credit score and current market rates, and just like a first mortgage, you can often tweak the loan terms (how long it takes to pay back the loan) to suit yourself. Remember, with second mortgages, loan terms are typically shorter than with a first mortgage; 10 or 15 years is more standard than 15 or 30.
Piggyback loans for down payments, explained
In this section, let’s walk through the most important ins and outs of piggyback loans.
A quick primer on down payments and mortgage insurance
The size of your down payment does matter. If you don’t have 20% to put down, your lender wants more protection in case you default on the loan. If you have less than 20% to put down, your lender will likely require you to purchase mortgage insurance (MI). This is an additional fee you’ll pay in order to get a loan with less than 20% down. A 20% down payment can be tough to scrape together in many markets (remember, we’re talking $40,000 on a $200,000 home for 20% down).
A piggyback loan is a second mortgage used to purchase a home so that buyers can avoid MI and secure a lower interest rate on their first mortgage, says Monley.
How piggyback loans work
Piggyback loans are often called 80-10-10 loans because the buyer takes out the first mortgage for 80% of the home’s value, a second mortgage for 10% of the home’s value, and then the buyer kicks in the final 10% on the loan as a down payment.
That means for a $200,000 home, you only have to come up with $20,000 for a down payment, and the piggyback loan for $20,000 will get you to $40,000 and 20%.
“Eighty-ten-ten loans are structured as two mortgages with a down payment,” explains Monley. “The first number always represents the primary mortgage, the middle number represents the secondary loan, and the third number represents the down payment.”
The piggyback loan is taken out at the same time as your main mortgage.
The pros of piggyback loans:
- You won’t have to pay mortgage insurance
- Mortgage interest on piggyback loans is tax-deductible (up to $100,000)
- A piggyback second could also be used to avoid having to qualify for a “jumbo” loan (a loan that exceeds the conforming loan limit in your area), which will often have more stringent underwriting requirements than your typical conforming loan
The cons of piggyback loans:
- Between interest and closing costs, you could end up paying more for your house over the lifetime of the loan
- You may have to pay two sets of closing costs
- Your second loan will likely have a higher interest rate
- You have to go through two loan closings at the same time
Other things to keep in mind with second mortgages
A second mortgage is another loan you’ll have to pay back on top of your first mortgage payment. If a homeowner defaults on either loan, the lender for the second mortgage can begin foreclosure proceedings — but whether or not it will actually foreclose depends largely on the value of the property in the current market.
If the owner has some equity in the home, then the second-mortgage lender is more likely to foreclose because they are more likely to reclaim at least some of the money loaned.
If the owner owes more on both the first and second mortgage than the house is worth, however, then the second mortgage lender might decide not to foreclose. They’ll make this decision because the likelihood that they’ll reclaim any of their investment is lower; proceeds from the foreclosure sale will be applied to paying off the first mortgage completely before any proceeds can be claimed by the second mortgage lender … so it won’t always be in that mortgage lender’s best interests to foreclose.
Whenever you take out a mortgage, make sure to choose the right lender. Some lenders might charge additional fees or higher rates than others.. When you begin prequalifying for a mortgage loan, ask several lenders to send you a Loan Estimate, which breaks down terms and fees in a clear and easy-to-compare format. On the second page of the Loan Estimate, you’ll find “Loan Costs” and “Other Costs.”
Loan costs will show you an itemized list of fees and services so you can compare the price of each item from lender to lender. And the other costs will include homeowners insurance premiums; take a look and compare these, too, to make sure you’re not being charged for anything extraneous or unnecessary.
If you’re using your second mortgage to make substantial improvements to your home or certain other activities, then you’ll be able to deduct your second mortgage loan interest on your taxes.
“I would tell people to use caution about the equity that they have in their house,” says Emma Payne, who ranks in the top 6% of top-selling real estate agents in Sussex County, Delaware, and has worked in the business more than 30 years.
Remember that second mortgages can change your life. A second mortgage could improve your life — maybe you pay off your credit cards or build an amazing backyard pool for entertaining using your second mortgage. But you’ll still have to pay your second mortgage back, along with your first mortgage.
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