Second Mortgages

A second mortgage is a loan that is in addition to your primary mortgage and secured by your home. It is called a 2nd mortgage because it is listed on the title in the second lien position. This is significant because if the house ever goes into foreclosure and is auctioned off, the sales price will first be used to pay off the lender in the first position and the remainder is used to pay off the lender in second position. Because of the inreased risk with being in the second position, these loans usually come with higher interest rates and have more stringent qualification standards.

There are two common types of second mortgages. The first is a home equity line of credit (HELOC) and the second is a fixed rate home equity loan (HELOAN). Home equity lines of credit are characterized by interest only payments for the first 10 years and an interest rate that is based on the prime rate. The prime rate is typically about 3% higher than the Federal Funds Rate, which is determined by the Federal Open Market Committee. Currently the prime rate is 8.25% and has been as low as 4.0% in 2003. The interest paid on a home equity line of credit may be tax deductable so you are encouraged to consult your tax advisor.

Home equity loans are fixed rate second mortgages that require principal and interest payments. Home equity loans are offered with many different terms, however the most common are 10 years, 15 years, or 30/15 balloon (the payment is amortized over 30 years but the entire principal balance is due in 15 years). The interest rate on the balloon is often lower than the 10 and 15 year terms and usually works well because most people will refinance or move within 15 years. If they do not; however; the amount that is owed after 15 years is so small that they can just pay it off.

There are many reasons for taking out a second mortgage. They can be used to consolidate debt, pay for home improvements, or virtually anything else you can think of. Additionally, they can be used to avoid making private mortgage insurance payments. Private mortgage insurance is only required when the loan is greater than 80% of the value of the house. For instance, if you want to purchase a house, but only have 10% to put down, you can take out an 80% first mortgage and a 10% second mortgage. In the industry, this is referred to as an 80/10/10 and often results in a lower payment than having a 90% first mortgage plus private mortgage insurance. This strategy can also be used on refinances if your loan to value ratio is greater than 80%.