Owning a house has several advantages, one of which is the chance to build equity in the home. The equity in your house is the sum of your mortgage debt and the property’s fair market value. You can access this equity in a number of ways, including by obtaining a second mortgage.
But what distinguishes a home equity loan from a second mortgage? We’re going to explore the alternatives in this article, so you’re armed with the knowledge and power to make the best choices.
As you consider the best way to move forward, it pays to check out all of your options, including eligibility for conventional loans. Now, let’s dive into the pros and cons of a second mortgage vs home equity loan.
What is a Second Mortgage?
Every mortgage loan that comes after a first mortgage is a second mortgage. A first loan is often a loan taken out to buy a house. Typically, first mortgages are bigger than second mortgages.
A second mortgage is secured by the house. The loan has to be returned with interest over time, just like a first mortgage. So, if you have got a first and second mortgage, you will have two mortgage payments each month.
Should you miss payments on either mortgage loan, the first mortgage provider supersedes the second mortgage lender in terms of payments. This implies that the first lender would be paid before the second in the event of a foreclosure, and it’s likely the second lender may receive very little or nothing at all.
Because of this, second mortgages often have higher rates of interest than first mortgages. Lenders are exposed to higher risk when borrowers have to make two mortgage payments as opposed to one. As a result, they make up for the likelihood the borrower will default by increasing the interest rate.
If you’re interested in exploring your mortgage options, including investor cash flow loans, contact The Mortgage Shop today. Our experts will be happy to discuss your options, and find solutions to help you move forward in your home ownership journey.
What is a Home Equity Loan?
A common form of second mortgage, which lets you take out loans against the equity you’ve accrued in your house, is a home equity loan.
If your home’s most recent assessment was for $500,000 and your mortgage debt is $200,000, you have $300,000 in equity.
You normally require a minimum of 20% equity in your house and can draw up to 80% of that equity, depending on the lender.
That amounts to up to $240,000 in this instance. The amount of your loan and its terms will also depend on a number of additional variables, including your credit history, income, and debt-to-income (DTI) ratio.
You are given a one-time, upfront cash payment. Over the course of the loan, you will likely make regular monthly payments at a fixed interest rate.
Second Mortgage vs Home Equity Loan
Second mortgages and home equity loans are actually just two different names for the same thing. A mortgage loan on a house guaranteed by the underlying asset is a home equity loan. However, it’s not the only type of second mortgage you can access.
On the plus side, being capable of accessing the equity in your house is the major advantage of a second mortgage. Flexibility is provided by a home equity loan since you can utilize the funds for almost anything. So if you wish to make some improvements to raise the value of your property, you may, for instance, remodel your kitchen. Alternatively, you might use the funds to pay down high-interest debt from credit cards and consolidate it.
For consumers with strong credit ratings, home equity loan rates of interest are often dramatically lower than credit card interest rates and even personal loan rates. You may be paying off a home equity loan quicker by choosing the shortest term of the loan feasible, but bear in mind that this will result in a higher monthly payment.
If you use the money from a home equity loan to buy, develop, or significantly enhance the property that supports it, the interest paid on the loan may be tax deductible. So once more, you might deduct the interest if you’re remodeling your kitchen to raise the value of your house or updating your HVAC system. The IRS does indeed have severe regulations in this regard, so you might want to discuss what is and isn’t permitted with your tax expert or financial counselor.
The fact that a home equity loan is backed by the property is its largest disadvantage as a second mortgage. This implies that if you experience payment issues with the loan, you may be more likely to experience default and finally, foreclosure. You would not only lose the house but additionally all of the cash you had put into it over the years.
When does a home equity loan stop being a second mortgage?
Home equity loans are not second mortgages if you have full ownership of your home and 100% equity in it.
Imagine, for instance, that you don’t have a mortgage anymore or that you paid cash for your property. The first lien on the property would then be a home equity loan. If you discontinue making payments, the home equity creditor has the power to foreclose on your house and use the sale profits to pay down the debt.
If you utilize the loan proceeds to settle your mortgage debt, that might also qualify as using the HELOC or home equity loan as a first-lien loan.
Is a line of credit or home equity loan treated differently from a second mortgage?
Lenders view second-lien loans as being riskier. If you cease making payments, lenders may suffer considerable losses because another claim takes priority.
You can anticipate stiffer qualifying conditions for the majority of second-lien loans, including such higher credit score minimums, because of this extra risk. They often provide fewer alternatives for repayment terms as well.
Compared to conventional first-lien mortgages, lenders demand higher interest rates for these loans. Additionally, most lenders require that you have 10% to 20% of your home’s equity left over after deducting the sum of your second mortgage. This provides a safety net in case the value of your house declines.
When a HELOC or home equity loan is used as a second mortgage, you will be able to borrow less. Once more, creditors want you to keep some equity so they are protected if the market declines.
Risk when taking home equity loans
Only variable rate HELOC loans are commonly offered. This implies that if you utilize your credit line frequently, you can wind up taking withdrawals during a period of high interest rates. If you’re not careful, you might wind up paying more in tax on your HELOC mortgage than you would if you’d taken up a second mortgage instead.
A credit line can be challenging to maintain as well because you can get it whenever you need it and you may be inclined to use it for things other than what you intended, increasing your debt. If you can’t make payments on a HELOC mortgage, you risk losing your home, just as with a second mortgage.
Risks when taking a Second Mortgage
You must immediately start repaying the second mortgage as well as the interest you owe. Your second mortgage might become a significant financial burden if you experience any personal financial difficulties, especially when you are paying it in addition to your first mortgage. You run the danger of losing your home if you can’t make payments.
When deciding whether to apply for a second mortgage vs home equity loan, there are many factors to take into account. However, a lot of your choice should be focused on your unique financial circumstances and your unique lending needs.
To pick the kind of second mortgage that best suits your requirements, think about how you’ll spend the money. An equity mortgage can be suitable for you if you need to cover a single large bill because of its lump sum amount. If you require long-term access to money, a HELOC can be a better option.
Fortunately, you don’t have to go through this process alone. If you want to discuss your unique situation and learn more about the best options for you from an experienced and reliable mortgage broker nearby, contact us today!