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Tuesday, September 13, 2011
Tuesday, November 24, 2009
Second mortgages
When you hear the term “second mortgage”, a negative connotation may come to mind. You may be thinking why would I need a second mortgage? I’m not in financial distress.
Well times have changed, and gone are the days when homeowners put down large down payments on their homes and pay off their mortgages in a matter of years. Nowadays, it’s quite common to hold a second mortgage, typically in the form of a home equity line as part of a combo loan.
Types of Second Mortgages
Many homeowners carry both a first and second mortgage, often closed concurrently during the purchase transaction. In these cases, the second mortgage is referred to as a “piggyback loan” because it sits on top of the first mortgage. Piggyback loans are used to extend financing terms, allowing homeowners to put less down on a home, or break up their loan into two separate amounts that produce a more favorable blended rate.
Two common formulas for a piggyback loan would be an 80/10/10 or an 80/20. An 80/10/10 translates to 80% on the first mortgage, 10% on the second mortgage, and a 10% down payment. An 80/20 is an 80% first mortgage, a 20% second mortgage, and zero down payment. Uh oh.
Second mortgages can also be opened after a first mortgage transaction is closed, as a source for additional funds. Homeowners can either elect to take a lump sum of cash in the form of a home equity loan, or choose a home equity line of credit (HELOC), which allows them to draw specific amounts when needed using an associated credit card which draws off equity in the home. Keep in mind that you need equity in your home to execute this type of transaction.
Second Mortgage Advantages
Second mortgages that are closed concurrently with the first mortgage during a purchase transaction are also referred to as “purchase money second mortgages”. As mentioned earlier, these allow homeowners to come in with a smaller down payment, or no down payment at all. During a purchase transaction, the homeowner can break up the total loan amount into two separate loans called a combo loan. The risk is split between the two loans, allowing higher combined loan-to-values and lower blended interest rates.
Second mortgages can also be opened after the purchase transaction is completed, as a home equity loan or home equity line of credit. This additional allowance of funds can provide a homeowner with much needed cash to improve the quality of their home or pay off high-interest loans, while avoiding a refinance of the existing first mortgage.
Second mortgages in the form of a piggyback loan also allow homeowners to avoid paying PMI, or private mortgage insurance. The savings can be quite substantial depending on how the loan breaks down, often saving the homeowner hundreds of dollars a month. If the first loan is kept at or below 80% loan-to-value, PMI needn’t be paid.
Monthly payments on second mortgages are typically pretty low relative to the first mortgage, but afford homeowners a large amount of liquidity if needed.
Second mortgages are offered in both adjustable and fixed-rate options, so you’ll have plenty of programs to choose from to find the right fit for your particular situation.
Cons of a Second Mortgage
Once you’ve got a second mortgage, it will be increasingly difficult to get any additional financing, such as a third mortgage. While it’s probably not common that a homeowner should require a third mortgage, emergencies do happen, and you may mind yourself trapped if you need more funds for any other reason.
Interest rates on second mortgages are typically quite high compared to first mortgages, and it’s quite common to receive an interest rate in the double-digits on a second mortgage. You could get a better deal with just one mortgage, or possibly even by paying mortgage insurance.
Many second mortgages are home equity lines of credit which are tied to Prime rate. Whenever the Prime rate is adjusted, the interest rate on your home equity line will change accordingly, effectively making it an adjustable-rate mortgage. When the Fed was raising the Prime rate month after month a year ago, many homeowners faced substantially higher monthly payments on their second mortgages.
Some home equity lines come with additional fees, such as an early closure fee, as well as minimum draw amounts that may exceed your personal needs. Make sure you read all the fine print to avoid any surprises.
Last but not least, a second mortgage is more debt, more interest due, and can potentially extend the amount of time it takes to pay off your mortgage.
All that said, there are a number of pros and cons to opening a second mortgage, but they shouldn’t be looked upon as negative financing instruments, rather just another option to consider when seeking home financing.
One quick note: Many mortgage lenders are reducing second mortgage programs as the secondary markets continue to grapple with credit issues, so you may find it much more difficult to obtain a second mortgage.
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Well times have changed, and gone are the days when homeowners put down large down payments on their homes and pay off their mortgages in a matter of years. Nowadays, it’s quite common to hold a second mortgage, typically in the form of a home equity line as part of a combo loan.
Types of Second Mortgages
Many homeowners carry both a first and second mortgage, often closed concurrently during the purchase transaction. In these cases, the second mortgage is referred to as a “piggyback loan” because it sits on top of the first mortgage. Piggyback loans are used to extend financing terms, allowing homeowners to put less down on a home, or break up their loan into two separate amounts that produce a more favorable blended rate.
Two common formulas for a piggyback loan would be an 80/10/10 or an 80/20. An 80/10/10 translates to 80% on the first mortgage, 10% on the second mortgage, and a 10% down payment. An 80/20 is an 80% first mortgage, a 20% second mortgage, and zero down payment. Uh oh.
Second mortgages can also be opened after a first mortgage transaction is closed, as a source for additional funds. Homeowners can either elect to take a lump sum of cash in the form of a home equity loan, or choose a home equity line of credit (HELOC), which allows them to draw specific amounts when needed using an associated credit card which draws off equity in the home. Keep in mind that you need equity in your home to execute this type of transaction.
Second Mortgage Advantages
Second mortgages that are closed concurrently with the first mortgage during a purchase transaction are also referred to as “purchase money second mortgages”. As mentioned earlier, these allow homeowners to come in with a smaller down payment, or no down payment at all. During a purchase transaction, the homeowner can break up the total loan amount into two separate loans called a combo loan. The risk is split between the two loans, allowing higher combined loan-to-values and lower blended interest rates.
Second mortgages can also be opened after the purchase transaction is completed, as a home equity loan or home equity line of credit. This additional allowance of funds can provide a homeowner with much needed cash to improve the quality of their home or pay off high-interest loans, while avoiding a refinance of the existing first mortgage.
Second mortgages in the form of a piggyback loan also allow homeowners to avoid paying PMI, or private mortgage insurance. The savings can be quite substantial depending on how the loan breaks down, often saving the homeowner hundreds of dollars a month. If the first loan is kept at or below 80% loan-to-value, PMI needn’t be paid.
Monthly payments on second mortgages are typically pretty low relative to the first mortgage, but afford homeowners a large amount of liquidity if needed.
Second mortgages are offered in both adjustable and fixed-rate options, so you’ll have plenty of programs to choose from to find the right fit for your particular situation.
Cons of a Second Mortgage
Once you’ve got a second mortgage, it will be increasingly difficult to get any additional financing, such as a third mortgage. While it’s probably not common that a homeowner should require a third mortgage, emergencies do happen, and you may mind yourself trapped if you need more funds for any other reason.
Interest rates on second mortgages are typically quite high compared to first mortgages, and it’s quite common to receive an interest rate in the double-digits on a second mortgage. You could get a better deal with just one mortgage, or possibly even by paying mortgage insurance.
Many second mortgages are home equity lines of credit which are tied to Prime rate. Whenever the Prime rate is adjusted, the interest rate on your home equity line will change accordingly, effectively making it an adjustable-rate mortgage. When the Fed was raising the Prime rate month after month a year ago, many homeowners faced substantially higher monthly payments on their second mortgages.
Some home equity lines come with additional fees, such as an early closure fee, as well as minimum draw amounts that may exceed your personal needs. Make sure you read all the fine print to avoid any surprises.
Last but not least, a second mortgage is more debt, more interest due, and can potentially extend the amount of time it takes to pay off your mortgage.
All that said, there are a number of pros and cons to opening a second mortgage, but they shouldn’t be looked upon as negative financing instruments, rather just another option to consider when seeking home financing.
One quick note: Many mortgage lenders are reducing second mortgage programs as the secondary markets continue to grapple with credit issues, so you may find it much more difficult to obtain a second mortgage.
Read more...
Discount rate, prime rate, and the federal funds rate
Ever wonder how the economy goes ’round? Or how inflation is controlled, and recessions are avoided? A lot has to do with the Fed and its tight control of key interest rates. (Latest rate cut 12/16/08)
Discount Rate (Currently 0.50%)
The Discount Rate is the interest rate the Fed offers to member banks and thrifts who need to borrow money to avoid having their reserves dip below the required minimum. The higher the discount rate, the higher mortgage interest rates will be. When the discount rate goes up, the prime rate goes up as well, which slows the demand for new loans, and cools the housing market.
The opposite is also true. If the fed lowers the discount rate, the prime rate will come down, and mortgage interest rates will dip to more favorable levels. This can boost a slumping housing market.
Prime Rate (Currently 3.25%)
Prime Rate is the interest rate offered by commercial banks to it’s most valued corporate customers. The prime rate is also the basis for many mortgage programs, including Heloc’s (Home Equity Line of Credit), which many banks offer to homeowners at prime plus X amount, prime minus X amount, or simply prime plus zero.
The prime rate always adjusts according to how the Fed changes the discount rate.
Federal Funds Rate (Currently 0 – 0.25%)
The Federal Funds Rate is what banks charge one another for overnight use of excess reserves. Banks avoid dipping below their required percentage of money on reserve by borrowing from one another.
The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks will be keen to borrow from one another, using the reserves to grant more loans which in turn feeds the economy. If the Fed feels the need to slow things down, they will simply raise the federal funds rate, which will curtail borrowing among banks and reduce the amount of new loans.
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Discount Rate (Currently 0.50%)
The Discount Rate is the interest rate the Fed offers to member banks and thrifts who need to borrow money to avoid having their reserves dip below the required minimum. The higher the discount rate, the higher mortgage interest rates will be. When the discount rate goes up, the prime rate goes up as well, which slows the demand for new loans, and cools the housing market.
The opposite is also true. If the fed lowers the discount rate, the prime rate will come down, and mortgage interest rates will dip to more favorable levels. This can boost a slumping housing market.
Prime Rate (Currently 3.25%)
Prime Rate is the interest rate offered by commercial banks to it’s most valued corporate customers. The prime rate is also the basis for many mortgage programs, including Heloc’s (Home Equity Line of Credit), which many banks offer to homeowners at prime plus X amount, prime minus X amount, or simply prime plus zero.
The prime rate always adjusts according to how the Fed changes the discount rate.
Federal Funds Rate (Currently 0 – 0.25%)
The Federal Funds Rate is what banks charge one another for overnight use of excess reserves. Banks avoid dipping below their required percentage of money on reserve by borrowing from one another.
The Fed uses the federal funds rate to control the supply of available funds, essentially controlling inflation. If the federal funds rate is low, banks will be keen to borrow from one another, using the reserves to grant more loans which in turn feeds the economy. If the Fed feels the need to slow things down, they will simply raise the federal funds rate, which will curtail borrowing among banks and reduce the amount of new loans.
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Home equity line of credit
A “HELOC”, or Home Equity Line of Credit is a home loan that allows a borrower to open up a line of credit using their home as collateral. It differs from a conventional home loan for several different reasons. The main difference is that a HELOC is simply a line of credit that allows a homeowner to borrow a pre-determined amount set by the lender, whereas in a conventional home loan, the amount borrowed is the total amount financed.
In other words, a HELOC is a lot like a credit card because of its revolving nature. When you open a credit card, the bank sets a certain limit, such as $10,000. You don’t need to pay interest on the total amount, or even withdraw or spend any of the $10,000, but it is available if and when you need it.
This is also how a HELOC works. Your bank or lender will give you a line of credit for a certain amount, say $100,000. And you can draw upon it as much as you’d like, up to that $100,000 if and when you want. It’s a good choice for homeowners because it allows them to use the line of credit if they need to, without having to pay interest if they don’t.
With a conventional home equity loan, you pay interest on the total amount borrowed. The HELOC not only gives the borrower the freedom to decide when and if to use the money, but also how much they need to pay back and when.
A HELOC normally has a 25 year term, with a draw period and a repayment period. The draw is typically the first 5 to 10 years, followed by the repayment period of 10 to 20 years. During the draw period, the homeowner can borrow as much as they’d like within the line amount, and can make interest-only payments on the amount drawn upon.
The HELOC interest rate is determined by the average daily balance and the prime rate plus the margin designated by the bank or lender. Most banks and lenders give borrowers prime rate with zero margin, or even less than prime. You’ll often see bank ads that say “prime -1%” or something to that effect. This is usually an introductory rate, and will often go up after the first few months.
If your loan scenario is a bit more high-risk, it could carry a margin up to 4% or more, which when combined with the prime rate, can be quite hefty. Prime is currently 7.75%, so adding a margin of 4% would make the interest rate 11.75%, which isn’t a very desirable rate.
After the draw period, the borrower must pay off the principal of the HELOC as well as the interest. This period is known as the repayment period. Usually the loan balance is broken down into monthly payments, but there could also be a balloon payment because of the way the loan amortizes. Also note that some HELOCs don’t have a repayment period, so full payment is due at the end of the draw period.
Many borrowers steer away from HELOCs for a number of reasons. The main reason being that a HELOC is an adjustable-rate mortgage, tied to prime. Whenever the fed moves the prime rate, the rate on your HELOC will change. Usually it’s only .25% at a time, but the fed has raised the prime rate about 20 times in a row since 2004, raising the prime rate from 4% to 8.25%. So your interest rate can fluctuate greatly, even if the fed moves prime in so-called “measured” amounts.
On top of that, HELOCs don’t have periodic interest rate caps like standard adjustable-rate mortgages, just lifetime caps, so the rate can fluctuate as much as the fed allows it to, up to 18% in California (it varies by state). HELOCs also come with early closure fees of around $300, although they don’t usually carry a prepayment penalty.
Most HELOCs are set up as a line of credit behind an existing first mortgage. They are opened behind the existing mortgage as a source of cash to pay down credit cards or other revolving debt, or for home improvements and other household costs. A HELOC provides flexibility at a relatively low interest-rate as compared to a standard credit card.
They can also be used as purchase-money second mortgages, meaning the full line amount is drawn upon at the time of closing. A purchase-money HELOC uses the entire draw of the credit line as a down payment on their home, and the borrower must pay interest on it from day one. For example, if a borrower wanted a zero-down loan on a $100,000 property, they would likely do an 80% first mortgage for $80,000 and a $20% second mortgage for $20,000. The first mortgage would likely be a fixed-rate mortgage or an adjustable-rate mortgage, while the second mortgage would be a HELOC.
The reason a borrower would choose a HELOC as a purchase-money second is usually because the interest rate is lower than the fixed seconds that are available. And a HELOC has an interest-only option which many fixed-end seconds don’t offer. HELOCs also don’t carry a prepayment penalty, whereas many fixed-end seconds will.
Some borrowers will even utilize a HELOC for their first mortgage, although it is less common and can be fairly risky for a homeowner.
HELOC advantages:
- lower rate than a fixed loan
- interest-only option
- no prepay
- ability to choose draw you want, when you want
- low fees
HELOC disadvantages:
- adjustable rate
- no periodic caps on interest rate
- early closure fee
- minimum draw amounts
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