Second mortgages are simply one way to access equity in real estate and is a financial tool to be used if needed strategically – the decision points on What – When and Why involve a few key details. Consider:
Are you concerned about rising interest rates, are you okay with taking on debt and monthly payments? The most common ways that homeowners access equity is through a conventional cash out first mortgage – second mortgages come into play for smaller amounts or shorter term needs or where a first mortgage may not fit due to expense or desire to keep the current first mortgage in place.
There are other options such as private money and reverse mortgages which are not covered in this article due to their sophistication but are discussed in other material.
In the second mortgage space there are a few things to understand; there’s a ‘traditional second mortgage’ which leaves the first mortgage in place – the second mortgage goes behind the existing first in subordinate position, which is why it is called a second. This means that the lender on the second mortgage has second priority if there were a foreclosure or sale – the first gets paid off first and then the second – so the second lien holder has greater risk.
Second mortgages are typically fixed anywhere from five or ten years all the way to 30 years – the payment is both principal and interest and the interest rate is fixed – just like a first mortgage. There are costs involved in second mortgages, although it usually costs less than a full refinance of a first mortgage.
The last and most common way people access home equity is a ‘Home Equity Line of Credit.’ It is more commonly known as HELOC and is essentially a giant credit card secured by your home – in second position – behind that first mortgage. It functions like a credit card; you can draw money, pay it back and then draw it again- typically you can do that for 10 years – after that you have to repay any balance over 10-20 years.
A HELOC will have lower payments than any of the other options, because typically the payments are interest only, you do not have to pay back the principal unless you want to. At the end of a ten-year period, you repay the HELOC over the next 10, 15, or 20 years and so the payment can jump significantly after 10 years. The other thing that could happen with the line of credit is that it can be closed at the lender’s discretion. Lenders can choose to close them for a variety of reasons – which is one of the risky things with a HELOC. A HELOC has the lowest cost of all the options, typically there is no cost or very low or a minimum cost.
The higher the dollar amount you need the more you want to think about a cash out refinance on a first mortgage or a new second mortgage. For lower amounts, consider the HELOC.
The longer you need the money; you’re going to want to look at a first mortgage or a second mortgage instead of the line of credit because the repayment for large sums of money ($100,000 to $500,000) can be a little harder to plan for. When you need $25,000 to $100,000, consider the line of credit.
What is your repayment plan? If you want to make monthly payments, you want to be consistent and you want to know the exact payment consider the second mortgage. If you think you can pay it off in chunks and just make a minimum payment from month to month and then make large payments every once in a while, maybe once or twice a year, then the line of credit is probably a way to consider.
From a Risk tolerance standpoint, the HELOC interest rates are typically variable – which is great when interest rates are low, but that can change. If you don’t like the idea of variable interest rates then you want to lean towards a second mortgage, but if you’re okay with managing a little bit risk, then a line of credit can be a great option due to its great flexibility.
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