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The Second Mortgage: What Are Your Options?

Posted by  on May 10, 2010
 
A second mortgage is a loan that is secured using your home as collateral, and is taken out in addition to your current existing mortgage. Second mortgages allow a homeowner access to cash in exchange for equity they have built up in their home. This is a popular method of obtaining cash for homeowners, as a second mortgage typically carries a much lower interest rate than a personal loan or credit card debt.

However, the second mortgage is a second lien on your home, meaning that this type of loan carries a higher risk for lenders, because if either loan is defaulted on, the second mortgage lender is second in line to receive money back from the sale of the house if foreclosure occurs. This means that a second mortgage, regardless of which form it takes, will carry a higher interest rate than your original existing mortgage.

Home Equity Loan

A home equity loan allows you to borrow money against the equity in your home. The amount you can borrow depends on the appraised value of your property, the existing balance of your mortgage, and the amount of equity you currently have in the property. The home equity loan works similarly to any other conventional loan, in that once the loan is approved; the borrower receives the entire sum borrowed as a cash advance. An average lender will allow you to borrow up to 75% of the property's appraised value, minus the balance of your mortgage. For example, if your home has an appraisal value of $200,000 and you owe $100,000 on the mortgage, you can borrow up to $50,000.

The interest rate on a home equity loan may be two or more percentage points higher than the interest rate on a comparable fixed rate conventional mortgage. The interest rate on this type of loan is typically fixed, and the loan is amortized for up to fifteen years (or longer, in some cases). The borrower can also opt for a shorter amortization period with a balloon payment due at the end of this period.

Home Equity Line of Credit

The home equity line of credit is similar in terms of the amount of money you can borrow. There are two major differences between this type of loan and a standard home equity loan. The line of credit typically has a variable interest rate rather than a fixed one, meaning that the amount of interest you pay can vary from month to month just as it does for an adjustable rate mortgage. The second difference is that rather than receiving the entire amount borrowed as a lump sum at the start of the loan period, the borrower has a draw period of five to 25 years during which they can draw funds whenever needed.

The biggest advantage of choosing a line of credit is that the borrower pays interest only on the money they draw, rather than on the entire sum as with a home equity loan. Both home equity lines of credit and loans also incur some finance charges, however they are typically not as hefty as the cost of getting a second conventional mortgage.

Conventional Mortgage

It's also possible to simply get a second mortgage in the conventional sense of the word. This works in exactly the same way as the first mortgage, except that it will carry a higher interest rate due to higher risk for the lender. There are closing costs and other fees to pay, just as with the first mortgage.

Which Option should you choose?

Each of these three options has some specific advantages and drawbacks, and is appropriate for use in certain situations.

In cases where you know exactly how much money you need, and you have a plan for using the money, a home equity loan or conventional second mortgage is usually the best option. You have the advantage a fixed interest rate in these cases, which provides you with the security of a monthly repayment that remains the same over the life of the second loan and allows you to plan your finances more accurately in the long term.

If your extra expenses are either recurring or variable, a home equity line of credit may be a better option. Even though you pay a variable interest rate, this is often a preferred option because you pay interest only on the money that you draw from the pool of available funds. However, there is risk involved with a line of credit in that it works in a similar fashion to a credit card in most cases you will actually get a card that you can use to withdraw funds from the loan account. This can make it very tempting to spend more than you plan to or need to, and the variable interest rate may potentially cause problems if you end up spending more than you intended early in the life of the loan.

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