What is a second mortgage?
A second mortgage is a loan that is secured
by the home itself, and subordinate to the
first mortgage. Any mortgage taken out
against a home in addition to an existing
mortgage automatically becomes a second mortgage.
As the name implies, second mortgages are secondary to first mortgages. This means if the homeowner is forced into foreclosure, the second mortgage holder will receive no proceeds from the sale of the home until the first mortgage has been completely repaid.
Characteristics of a typical second mortgage:
- Since the lender's risk is higher, second mortgage loans carry a higher interest rate than first mortgage loans.
- Second mortgages are typically shorter in duration (usually 15 years or less).
- A second mortgage may require a "balloon" payment at the end of the repayment period.
- This one is a biggie: the interest paid on a second mortgage is tax deductible in most circumstances!
Primary types of second mortgages:
- Home equity loan - This is the traditional type of second mortgage. There is a one-time disbursement of the loan funds (in a single check) followed by a period of regular monthly payments and a fixed interest rate.
Home equity loans are often used to consolidate debts, remodel the home, fund a college education, purchase a big ticket item such as an RV, or most anything that requires a large amount of cash.
- Line of credit - This type of second mortgage is very different from a home equity loan. With a line of credit, you don't receive a large check for the full amount up front. You may never even borrow any actual money from it at all!
The interest and payment on a line of credit second mortgage can and does change periodically. The interest is typically tied to the prime rate. The actual interest rate will be the prime rate + a certain number of percentage points.
For example, your loan specifies that you will pay the prime rate + 5%. If the prime rate is currently 6.5%, the interest rate on your loan will be 11.5%. The interest rates will be evaluated periodically, and if the prime rate has changed, your interest rate will change along with it. Of course your monthly payment will also change accordingly.
A line of credit second mortgage is just that: an amount of money that you can borrow at a future date as needed. This amount is available to you all at once or in several small disbursements spread over many years.
For example, you apply for and get approved for a $50,000 line of credit (secured by a second mortgage on your home). You can borrow the entire $50,000 at one time.
Alternatively, you can wait a few months and borrow $20,000 for a new car. A few months later you can borrow $6,000 to add a room to your house. Later still, you can borrow another $3,000 to pay off a credit card bill.
So far you will have borrowed $29,000, meaning that you have $21,000 left on your line of credit that you can borrow later if you need to.
Second mortgages allow homeowners to tap the equity in their homes to purchase expensive items, pay of debts, or most anything else.
Home equity loans are usually used to fund a present need while lines of credit are often established for use at some time in the future.
It is very important that you use a second mortgage wisely because if you get into financial trouble you can potentially lose your home. But if used properly, a second mortgage can help you enjoy a better lifestyle, now and in the future!
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