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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