These are challenging times for someone looking to buy a home, but the obstacles in the real estate market (such as rates that are higher than those of a few years ago) open up new opportunities for homeowners.
The reason is that homeowners have a considerably more considerable amount of equity than in the past. Based on data company CoreLogic, homeowners, on average, earned nearly $60,200 in home equity (the value of their home minus the mortgage amount) in the 2nd quarter of last year.
However, skyrocketing mortgage rates have significantly reduced the attractiveness of a home equity solution: cash-out refinancing. Homeowners are becoming less willing to pass up a competitive first mortgage interest rate in return for cash. According to Point’s study of mortgage financing platforms, about 35% of property owners are foregoing refinancing because of rising rates. As a result, more homeowners opt for a secondary mortgage, a line of credit or a home equity loan.
If your assets have grown and you own a home, taking out a second property loan may be tempting, but does it fit your situation?
What is a Secondary Mortgage?
Second mortgages, referred to as junior liens, involve borrowing funds secured against your home. This loan is separate from and in addition to your main mortgage (used to buy your home).
A second mortgage is strongly similar to a primary mortgage. The only difference is its priority position in case you cannot meet your mortgage repayments, and the house is put up for sale to clear your debt, says Tabitha Mazzara, manager of operations at MBANC, a local California mortgage lender.
“If an incident occurs and the client defaults on a loan, your first mortgage gets priority,” Mazzara explains. “So such a loan is riskier for the funder. The credit conditions that need to be met can be more restrictive than for an individual shopping for a primary mortgage since the lender is in a stronger position with [primary mortgages].”
Given this heightened state of risk, the interest rates on second mortgages are generally higher than those on first mortgages.
A home equity loan and HELOC (Home Equity Line of Credit) is often called a second mortgage, as the house is used as collateral and is in second place to the principal mortgage.
Typical Applications of Secondary Mortgages
Secondary mortgages don’t have many limitations. The funds obtained through this mortgage can cover subsequent expenses, even though there might be better financing solutions.
A HELOC or home equity loan is typically for financing home renovations and notable redevelopment projects that may involve a substantial initial investment.
Since the interest rates on a second mortgage are lower than those on a credit card or personal loan, it is sometimes chosen for consolidating debts with higher levels of interest. However, many financial advisors caution against turning a non-guaranteed deficit into a guaranteed one, as you could lose your house if you don’t pay off your debt.
Categories of Secondary Mortgages
Two main categories of secondary mortgages can be distinguished: a home equity loan and a HELOC.
Home Equity Loans
With home equity loans, you borrow funds from your home’s equity to obtain a cash advance. Usually, this type of loan has fixed interest levels, and the repayment term is set between 5 and 20 years.
“They’re usually a solution to take advantage of lump sum funds to lock in a certain interest rate, borrow as much as you want and pay it back within a specific number of years,” explains Sarah Catherine Gutierrez, a licensed financial advisor and chief executive officer at Aptus Financial. in any other situation where you are aware of the amount you need to take out.”
Benefits and Drawbacks of Home Equity Loans
You must be aware of the benefits and downsides of home equity loans.
Since your home is the guarantee for your loan, it typically has reduced interest rates compared to other types of credit, like a personal loan or credit card. Since the interest is fixed, your monthly installment is consistent and predictable. Finally, if you take out a loan for renovations, the interest charged is likely tax-deductible.
But, a home equity loan is only granted to those with sufficient equity in their home. If you’ve just purchased your home, you may be ineligible.
Since a home equity loan gives you a lump cash, you may need alternative funding options if your proposed project costs more than anticipated. It may come with closing costs ranging from 2-5% of your mortgage amount.
HELOCs
Although HELOCs are used to borrow from your home equity, they function quite differently from traditional home equity mortgages. Unlike a cash lump sum, this type of credit offers you a renewable credit line.
Benefits and Drawbacks of HELOCs
You may use the HELOC many times throughout the HELOC drawdown period (for example, the first decade). In the case of certain HELOCs, payments are made only on the interest earned throughout the drawdown period, making the payments relatively small, and you are only paying interest on the credit amount used.
Unlike a home equity loan, the rates of a HELOC are typically variable (although lenders give fixed rates for HELOCs). With a floating rate, the interest is subject to fluctuation throughout the year, changing your monthly installment. For borrowers holding an interest-only HELOC, where payments made over the draw period include interest only, the end of this period can be a surprise; your fees will involve both principal and interest and could be noticeably more costly than they used to be. Additional fees may be incurred with HELOC, including yearly assessments, inactivity fees or costs for early termination.
Benefits
- Continuous access to funds
- Interest payments are only on the amount you take out
- Monthly repayments may decrease for drawdown
Drawbacks
- Interest rates are generally variable
- Repayment term may cause a surprise
- Possibility of additional costs
HELOCs vs. Home Equity Loans: Which To Choose?
None of these products may be preferable to all, so keep your spending and objectives in mind.
Plan to make an expenditure and know precisely the amount required. Whether it is to order new cabinets or consolidate existing debt, a home equity mortgage can be an attractive option. You will have an initial money and a fixed payment each month.
If you don’t know how much it will cost or are looking for more flexibility to handle unexpected charges, a HELOC is your best choice. That’s because you can borrow from the revolving credit line repeatedly, and you’ll only pay off the interest on the money used.
Beware that by taking out a 2nd mortgage, you end up adding to your total mortgage debt. This situation can become risky, according to Gutierrez.
“If you take out an additional mortgage and the value of your home drops, what will you do under those circumstances? ” she replies. “What happens if you look to sell it? Your debt will be greater than the value of your home.”
Before getting a loan, ensure you can pay the monthly payments and overcome the loss of net worth.
“For many people, it’s a bad time to deal with new and large discretionary costs,” explains Guttierrez.
What Do I Need to Do to Get a Secondary Mortgage?
If you are looking to take out a second home mortgage and apply for a HELOC or home equity loan, do the following:
- Establishing equity: Creditors will only give you a certain amount of equity, with a limit set by many creditors at 80% of your available equity, so it may take a while to obtain a loan or a HELOC.
- Check your credit: You usually need good or excellent credit to be eligible for a 2nd mortgage. Examine your credit records to confirm the accuracy of the information, and strive to pay off existing debts and make all payments promptly to strengthen your credit rating.
- Select a lender: Pricing and terms may vary from lender to lender, so compare quotes from several banks or financial cooperatives. When possible, request estimates in a short time frame (e.g., 15-30 days) to reduce the effect on your creditworthiness.
- Gather documentation: When applying for a 2nd mortgage, you will need to bring proof of employment, such as pay slips or tax reports, up-to-date mortgage records, and a copy of your property insurance policy.
- Send in an application: After submitting your request, lenders will run a thorough credit check on it. They will also look at your debt-to-income ratio and whether or not you have the resources to make two mortgage payments.