Taking a second mortgage will allow you to either receive a lump sum of money or open a new home equity line of credit (HELOC). How much equity you have is determined by the balance of your original mortgage loan and the value of your home. For example if your home loan is $75,000 and the value of your home is $100,000 than you have $25,000 in home equity. When you decide to access the equity you have in your home through a second mortgage the bank will put a lien on your house. This means that if you default on the loan the bank will be able to take possession of it.
For a variety of reasons, many homeowners sometimes take a second mortgage. They may use the money for home repairs, their children’s college tuition or to pay for a vacation. But if you’re not careful a second mortgage could lead to the loss of your home and/or bankruptcy. Let’s take a look at a few of the risks and benefits of the second mortgage.
Benefit – Affordable Housing
If you take out both your primary and second mortgage at the time of your home purchase, often referred to as a “piggyback loan” or a “purchase money second mortgage,” you may be able to lower your interest rate which can translate into significant savings. You may also be able to avoid paying PMI (private mortgage insurance) if you can keep the primary loan at or below 80% of the value of the home. Paying a lower interest rate and not having to pay a PMI every month will save you tens of thousands of dollars over the course of your mortgage.
Risk – No Additional Credit
Once you take out a second mortgage, it may be next to impossible to get a third one. This is especially true because second mortgages usually devour what’s left of your home equity. Even if it doesn’t, some lenders might be hesitant to lend to you if it seems you’ve taken on too much debt. In the short-term this may seem okay, but in the long-term you need some type of cushion. Without it you may be unable to cover all of your bills when an emergency hits. Even worse, if you lose your source of income and the value of your home declines, you could end up with an underwater mortgage with no way to sell your home and pay off your mortgage. It’s this lack of flexibility that can force you to file bankruptcy when you’re in a financial pinch.
Benefit – Emergency Credit
Another benefit of a second mortgage is that you can take it out as an equity line of credit. This may be helpful if you are looking to consolidate debt or struggling with financial hardship. While the interest rates on a HELOC are usually higher than the primary mortgage they tend to be lower than most credit cards and loan providers. This may help you pay off debts that you were struggling to get rid of due to high interest rates. Or if you are in a financial bind HELOC lines of credit usually have the option to make interest only payments which may help you until you recover financially. Also the IRS lets you claim the interest you pay on your HELOC if your debt is less than $50,000, which you cannot do with the interest you pay on your credit cards.
Risk – Variable Credit
Home equity lines of credit usually come with a variable interest rate. That means that the interest rate will go up and down while you access the credit. This could result in a significant increase in your monthly payment. So it’s important to evaluate your monthly expenses when deciding if a home equity line of credit is right for you. Be prepared for rate spikes and the additional costs by giving yourself some extra cushion in your budget so you are not left financially vulnerable. The consequences are great if you miss monthly payments as the bank could force you out of your home.
Before you take out a second mortgage carefully consider whether the benefits outweigh the risks.