Your first mortgage is the original loan that you used to purchase your home. The lender uses the property as collateral. The borrower pays back the loan in monthly installments. As time passes, the borrower pays down his debt as the value of his home rises. The borrower’s home equity is the difference between the home’s fair market value and the outstanding balance on the mortgage.
A second mortgage, also known as a home equity loan, is borrowed while the original mortgage is still active. In essence, a homeowner takes a loan against his home equity. As a result, this type of mortgage usually is a lump sum.
As with any loan, the borrower must repay the second over a specified loan term with the added interest rate. Interest rates are often lower than credit card interest rates but slightly higher than your first mortgage’s interest rates. If you default on your loan, your first mortgage lender will get paid from the sale of your house before your second lender. Therefore, you can expect a higher rate because second lenders take on more risk.
There are two primary types.
One type is “home equity loan.” It is similar to a personal loan, where the lender pays the borrower in a lump sum at a fixed interest rate. Comparable to your first conventional mortgage, these loans usually have a 15- or 30-year term.
Another type is a “HELOC” or a home equity line of credit. This type of loan is renewable. It is similar to a credit card or a personal line of credit. Once the borrower repays the principal, the credit line renews and can be used again.
Instead of a fixed interest rate, this investment carries a variable rate. HELOC’s come with a draw period. During this time, the borrower can withdraw money and pays only the interest each month. During the HELOC’s repayment period, the borrower must pay both the principal and interest.
Most homeowners consider this mortgage because it allows you to borrow a significant amount of money at one time. Most lenders will grant a second loan up to 85% of the “loan-to-value ratio” of both mortgages combined. As a result, consumers may choose to use the funds for home improvements, medical bills, college education, or debt consolidation.
If you are considering this type of mortgage because you are in some financial strait, you may be putting yourself in further financial jeopardy. Second mortgages can give you cash upfront, but it significantly increases your monthly expenses during the repayment period. Two mortgage payments can put a tremendous strain on your income.
Furthermore, like with your original mortgage, your house is the collateral in your second loan. As a result, if you don’t pay up the loan, the bank can seize your property.