- Second Mortgage vs. Cash-out Refinancing
- HEL & HELOC
A second mortgage is another (secondary and subordinate to the existing first mortgage) loan that you take out using your home’s equity as collateral. It provides you with cash, but it deprives you of the owned by the time part of your home, partially or completely. You have to start buying out your home practically all over again, this time on different terms – the terms of the second mortgage. What’s in the terms?
The crucial distinction of a loan secured by home equity is that the cash acquired can be used for anything – a new car, college tuition, or a bagful of groceries. It is not limited to one purpose only, as most other loans.
A second mortgage can be practically of any type. Some are easier to shop for, some are harder to find, but it’s all in your hands, backed up with your credit score. The complication factor is that a second mortgage is literally second in the queue for refund in case you default on your mortgage payments. The lender of the second mortgage will not have a cent of his money back until the lender of the first mortgage gets all that’s his first. Sometimes it is all that there is and there is nothing, or way too little, left to pay back to the second lender. This unavoidable risk of a second mortgage usually makes it more expensive through a higher interest rate in the lender’s attempt to compensate for a potential financial loss.
The first lender may also take notice of your second mortgage activity and extend the period of your PMI payments on the first mortgage, if you had any.
A second mortgage imposes certain risks on the borrower, too. One of them is second mortgage subordination. It is very important to have a clear subordination statement included into the second mortgage contract. Failure to do so may (and very likely will) make it impossible for you to refinance your first mortgage as long as the second mortgage is not paid off. When you take out your second mortgage, the lender agrees to subordinate it to the existing first mortgage on the existing terms. Any change in this balance may not be welcome, so make sure the subordination clause leaves you free to refinance your first mortgage at will.
No third loan of any kind – sad, but true – having two mortgages disqualifies you heavily from getting a third loan, should a need for it arise.
If the only purpose of your second mortgage is to raise some cash, you may also consider cash-out refinancing or a HELOC as its alternatives. Cash-out refinancing may happen to be more sensible if rates have dropped and the new mortgage will bear a rate lower than the rate of your current first mortgage. Watch out for PMI, though!
A HELOC is an adjustable rate mortgage that acts as a line of credit. It is secured by your home equity, so the interest rate is usually a lot lower than that of a credit card, and the interest paid is usually tax deductible (consult a tax advisor for details!). You get assigned a certain amount as your credit limit and after that you can draw different sums at different times, keeping the overall amount drawn within this credit limit. Your monthly payment includes the interest and, when some of the credit is used, a monthly minimum payment on your outstanding balance. Apart from that you determine how much you pay back and when. Usually, you have a 10- to 20-year period when you can draw on the line, after which you have a fixed period to pay off the outstanding balance plus interest.
The credit limit of a HELOC is up to 100 percent of the value of your home (its value minus all debts against it). Some lenders will allow you to borrow up to 125 percent of the value of your home, but don’t consider this to be easy money! However attractive the conditions may look, don’t forget – it’s your home you are gambling about! Should you default on your payments, that same lender who talked you into a 125% HELOC will knock on your door to tell you that it is not your home anymore.
A HELOC is usually a second loan, but it can also be a first one, if it was the first one you started after you had built 100% equity in your home. If you use your HELOC to pay off your existing first mortgage, the HELOC itself becomes a first loan in its stead.
A HELOC may be convenient for a person or a family, who will need to make a number of various payments over a stretched out period of time: for example, for home remodeling and a new car, or tuition and medical bills etc. Most home equity loan programs, unlike conventional mortgages, allow borrowers to use the money for whatever they wish.
People looking for a lump sum solution based on their home equity might want to consider HEL as an alternative. You can cash out by mortgaging up to 85% of your home’s equity. A HEL is usually a fixed rate mortgage, so the interest rate is lower than that of a HELOC (but higher than a conventional 30-year!). In fact, many HELOCs allow the borrower to draw a portion of the available balance and “lock it” thus turning that chunk of money into a HEL. The payment structure of a HELoan is identical to an equivalent conventional mortgage, but unlike the latter one, the cash can be used for anything.
You can use our calculator to estimate the costs of a HELOC.
In conclusion, I want to draw your attention to another very important issue that you should always bear in mind while considering a second mortgage at all: a second mortgage may prevent you from moving to a different location. If you happen to need to move to a different city, you may find it very difficult to sell your current home if your overall debt against this property exceeds its current market value. The money you will be able to get by just selling it will not be enough to pay off all the mortgages. All you’ll be able to do is default, and that’s really bad, because it ruins your credit score and makes it impossible for you to get a new loan at the new location. So my advice is always – do not drain the equity of your home too easily, especially during the times when real estate prices are not rising.
