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Are you considering a second mortgage on your house, but aren’t quite sure of the meaning of a second mortgage, or if a second mortgage will even work for you? The following tips will hopefully equip you with sufficient information to make an informed decision as to whether a second mortgage is right for you.

Second Mortgage Definition

Like your “first” mortgage, the “second” mortgage is secured by the house itself, or more correctly, by the accumulated equity in the house. Example: If your house has an outstanding mortgage of $100,000, and an appraised value of $150,000, you have a theoretical amount of $50,000 that could be available for a second mortgage. Conversely, if the outstanding mortgage is $150,000 and the house is appraised for $100,000, you are underwater without excess equity available for a second mortgage.

Your second mortgage involves greater risk to the lender because it is always subordinate to your first mortgage. If your house goes into foreclosure, the holder of the first mortgage gets paid first, before the holder of the second receives one penny.

Because there is always greater risk to the lender with a second mortgage, you must expect to pay a higher interest rate on the second to adjust and compensate for the higher risk.

There are two basic types of second mortgages, with all kinds of creative variations in between:

1. Home Equity Loan – This is the original second mortgage. It involves the disbursement of a lump-sum check at the time of closing, followed by regular fixed-rate monthly payments throughout the term of the loan. The Home Equity Loan is popular for the purchase of big ticket items such as the kid’s college tuition, home remodeling, buying that dream vacation home, or just about anything requiring a lump-sum payment. Since the interest on auto loans is no longer tax deductible, whereas the interest on second mortgages is, many people actually take out a second mortgage to buy their cars.

2. Line of Credit – Unlike the home equity loan, the line of credit does not involve the disbursement of a lump-sum check up front. It does involve making a lump-sum of money “available” for you to draw down as you please. You have the options to draw it down all at once, draw it down in dribbles and drabs, or you may not even draw it down at all. The comfort is in knowing it’s there if you need it. The interest rate on the line of credit, unlike that of the home equity loan, is not a fixed rate. It is typically “pegged” to the Prime rate [e.g., Prime +5, Prime +6, etc.]. Thus, if the prime rate is 4%, in the case of Prime +5, your interest rate would be 9%. Expect your lender to conduct a periodic review of the Prime rate. You may also expect that your interest rate on the outstanding balance will be adjusted accordingly as the Prime rate changes. The key feature of the line of credit is that you are only liable for the amount of funds you actually draw down.

Common Characteristics of Second Mortgages

1. They involve higher risk to the lender, so the interest rate on second mortgages is always higher to compensate for the risk.
2. The interest rate on second mortgages is always tax deductible.
3. Second mortgages always have a shorter life span than first mortgages, typically less than 15 years.
4. Second mortgages may, or may not, require a balloon payment at the end.

Summary

The second mortgage is your security blanket, not to be used frivolously. During these uncertain economic times, families are losing their homes just trying to keep up with their first mortgage without the burden of a second mortgage.

Use your second mortgage wisely, to advance financial or lifestyle opportunities of a non-speculative nature that you are absolutely confident you can manage. If you are at the brink of financial disaster, the second mortgage is not the route go as it will only buy you a little time while increasing your financial problems exponentially.

On the other hand, second mortgages are proven to enhance the quality of the family’s lifestyle. They bring within reach big-ticket items, which would be out of reach to ordinary families who do not make a practice of keeping a lump sum of cash stashed away. Again, use the second mortgage wisely.