Second Mortgages
A second mortgage, just as its name implies, is a second loan secured by the same property as a first mortgage. Second mortgages are often hybrid loan products that take features from both traditional mortgages and consumer credit practices. There are several things to keep in mind when considering a second mortgage:
- Lenders consider second mortgages to be much riskier than first mortgages. In the event of default, the second mortgage lender gets paid off only after the first mortgage lender is paid in full. Because of this additional risk, lenders usually charge a higher rate for second mortgages than for first mortgages. Also, such loans are commonly adjustable rate mortgages, so lenders are largely protected against inflation.
- If you are buying a home, a second mortgage can help supplement your down payment and closing costs. As long as you are able to make the proper payments, the lender shouldn't have any objections.
- If you are financing to get cash out of your property, a second mortgage or home equity loan may be cheaper than replacing your first mortgage.
- Second mortgages have shorter terms, typically ranging from 5 to 15 years. In contrast, most first mortgages have terms of 15, 25 or 30 years.
- A second mortgage in the form of a credit line can advance you cash with relatively little cost up front. In addition, the interest rate is usually far lower than you would normally pay for unsecured consumer credit.
01. Combined Loan-to-Value Ratio
If you have a $200,000 home and a $140,000 first mortgage, the loan-to-value (LTV) ratio for that mortgage is 70 percent ($140,000 / $200,000). If you also have a $30,000 second mortgage in addition to your first mortgage, your combined loan-to-value (CLTV) ratio is 85 percent ([$30,000 + $140,000] / $200,000). Your CLTV ratio is the sum of all your mortgages divided by the current value of your home.
When granting a second mortgage, most lenders will limit your maximum CLTV ratio. Depending on loan purpose and occupancy type, the maximum CLTV will range from 70 to 90 percent. The interest rate for this type of second mortgage is at least 2 percent to 3 percent higher than the rate for a 15-year first mortgage. If your CLTV ratio is more than 80 percent, don't be shocked if the rate for your second mortgage is 3 to 7 percent higher than a conventional 15-year first mortgage.
02. Home Equity Lines
Consumer borrowing through personal loans and credit cards is at an all-time high. Many people are buried under thousands of dollars of debt with interest rates of 18 percent or more. A new breed of mortgage lenders has created a brand new class of second mortgage products designed to help consumers get out from under their mountain of debt.
These loans are commonly called equity lines, home equity lines, home equity lines of credit (HELOCs), or debt consolidation loans. These loans have interest rates that are much higher than traditional first mortgages but are usually much lower than interest rates charged on credit cards.
There are no standard loan types for these second mortgage programs. The only common feature is that all of these loans are secured by a lien on the borrower's home. Unlike credit card debt, if the borrower fails to make a payment, the lender can foreclose on his home.
Some of these loans are structured like credit card debt and can actually be accessed with credit cards or checks. Others are fixed rate, amortizing loans or balloon loans. Up until recently, some lenders were eager to loan up to 125 percent of a home's value. A CLTV ratio of 125 percent is unthinkable in traditional mortgage lending.
03. Purchase Money Mortgages
When the seller of a property offers a loan to the buyer, it is called a purchase money mortgage. Typically, the seller "takes back" a second mortgage to facilitate the sale when a buyer does not have the required amount for the down payment and settlement costs. Purchase money mortgages are often made in combination with an assumable first mortgage. A seller will often loan money at a better rate than a traditional lender.
04. Consumer Credit vs Real Estate Financing
Traditionally, real estate has been considered a nonliquid asset; property that can be converted to cash only by selling or refinancing. Real property financing is a very lengthy and expensive way to raise capital. But the conventional perception of real estate is changing. Today property can be converted to cash almost immediately through the use of a second mortgage secured by real estate.
Consumer credit differs from traditional real estate financing in 3 important ways:
- Credit card charges represent unsecured debt. When you make a credit purchase the issuing card company advances money to the retailer on the theory that you will repay the debt. Real estate debt, on the other hand, is secured by the value of your property. If you don't make the payments, the property will be sold to pay off what you owe.
- Real estate loans are typically advanced at one time, in one lump sum. Credit card debt is usually a revolving line of credit. You may have the right to borrow $10,000 from a single credit card company but you don't have to. If you borrow only $500 you pay interest only on the outstanding balance. In addition, once you pay back the $500 you can again borrow up to $10,000. With most real estate financing, it goes without saying that once you pay back any portion of the principal the lender is not obligated to grant you another loan.
- There are usually no fees involved to get consumer credit. Hundreds of companies will gladly send you credit cards with the hope that you really do buy now and pay later. Real property lenders will not only charge a considerable fee to apply for financing, but they also have a long list of closing costs that the borrower has to pay.
05. Problems
Home equity loans have several inherent features that should concern potential borrowers.
- Since a home equity loan is secured with a lien on property, a borrower who defaults can be foreclosed. Consider this: A homeowner has a $20,000 credit line, becomes unemployed and for whatever reason borrows $200 on a credit line mortgage, which is not repaid. Can a lender really foreclose if the outstanding balance is only $200? Yep. Will a lender necessarily foreclose? The answer depends on the lender's policies, but in the interest of good public relations it's likely that most lenders would try to work something out before foreclosing.
- A second possible problem is that some second mortgages may actually be too accessible for some borrowers. Many otherwise responsible people overextend themselves with unsecured credit card debt, so it's likely that some borrowers will do the same with secured credit lines. Currently, lenders often permit the withdrawal of relatively small sums; often less than $500. Lenders should probably set higher minimum withdrawals to prevent frivolous expenditures that can result in foreclosure.