Understanding a Second Mortgage

Author: Mike Cotter

A second mortgage is a loan that you take against the equity that you have already built into your home. The proceeds from the second mortgage can generally be used for whatever purpose the borrower has in mind.  It can be used to pay off a car loan or credit cards. The proceeds can be used for home improvement or to take a vacation. The money can even be put in a savings account for a rainy day fund.

Historically the total amount of debt from the first and second mortgage combined could not be more than 80% of the total market value of the home. However,  low interest rates and a competitive marketplace have created a lending environment where some lenders are approving second mortgages that, when combined with first mortgage balance, is totaling as high as 125% of the home value.

However, financial advisors will tell you that carrying that much debt on your home is never a good idea. I never recommend borrowing more than 100% of the value of your home and I rarely recommend a second mortgage with a loan to value of greater than 90%.

Because a second mortgage is a property lien that is placed behind the first mortgage, this means that in the event of a default, after the property is sold the first mortgage gets paid first, including any legal costs and other costs of the sale, before the second mortgage can be paid. If there is not enough money from the sale of the home, the second mortgage does not get paid.   A Higher Interest Rate

When determining the interest rate that a lender is willing to loan money out for a home mortgage, he looks at the risk level to him for loaning that money.  This is the reason that a high risk borrower with a poor credit history gets charged a higher interest rate than a low risk borrower with a strong credit history.

The same theory holds true with a second mortgage. Because the lender of the second mortgage is second to be paid off in the event of a default, and because there is a greater chance that there might not be enough equity in the home to pay off the second mortgage in full, second mortgages are usually given at a higher interest rate than are first mortgages; irregardless of who the borrower is.   Terms

Although you will have choices for terms when selecting your second mortgage, in general the terms given for them are shorter than those of a first mortgage. This is primarily because the amount of the second mortgage is generally much lower than that of the first mortgage.

Second mortgage repayment terms can vary considerably, so it is important that you look around for the one that is best for you. For the most part they range in length from 5 to 20 years, with the majority of second mortgage loans being 10 to 15 years. A select number of lenders will offer a 30 year amortization and some of them will balloon (set a maturity date) of 15 years. This loan is called a 30 due in 15. Generally, just like first mortgages, the longer the maturity, the higher the interest rates.  Also, just like first mortgages, the higher the credit score (FICO) the lower the interest rate.

Just as the length of the second mortgage can vary, so can other repayment terms. The majority of second mortgages are paid back in equal monthly payments with a portion of the payment going to interest and a portion to the principal balance, just like a first mortgage. Types of Second Mortgages

The two most common types of second mortgages are the fixed rate and the HELOC (home equity line of credit). The former is a standard offering.  The HELOC is a little unique and has been very popular.  The loan typically calls for interest only payments for the first 5 to 10 years and then the line of credit is frozen at the outstanding balance of the loan.  At that point, the loan payments are recast and a standard principal and interest payment is established for the remaining 10 to 20 years.  The HELOC's are typically priced with a variable interest rate that is most commonly indexed to the New York City prime interest rate.

Pricing on the HELOC's is like other loan pricing; the lower the FICO score and the higher the loan to value, the higher the interest rate.

When considering a second home mortgage, be sure to shop around and then talk to lenders to ensure that you get the best deal for you!

About the author: Mike Cotter has been a professional lender for over 30 years. He began his career in the commercial banking industry in 1972 and steadily progressed to become Vice President of Retail Banking with a major Denver bank. In 1982 he opened his own commercial bank and served as President and CEO for 10 years. In 1992 he left commercial banking for the mortgage banking field. Rocky Mountain Mortgage Rates