Tap to Read ➤

How Does a Second Mortgage Work

Aparna Iyer Jan 11, 2019
A second mortgage can be useful for a person in need of money for home improvements and debt consolidation. It can also serve as a piggyback loan, an alternative to private mortgage insurance.
A traditional mortgage enables a person to buy a house by borrowing money from the mortgage lender. Generally, banks and credit unions are preferred lenders since they are willing to provide loans at relatively low rates of interest. The borrower is expected to make principal and interest payments on the loan, over a period of 30 years.
The interest rate is fixed and inability to discharge the amortizing loan will result in the house being repossessed by the lending institution. It's evident that making mortgage payments is a serious obligation and negligent behavior can result in a person losing his home. In this situation, caution should be exercised while availing any additional loans.
A second mortgage, which uses the same house as a collateral for obtaining additional funds, is definitely undesirable. However, people may still decide to obtain it because of pressing financial concerns.

Understanding a Second Mortgage

A second mortgage uses the same house as a collateral for obtaining a loan from the mortgage lender. Since the same house functions as a collateral for the primary mortgage, the primary mortgage lender has prior claim on the house in case of default. This makes the secondary mortgage lender's position somewhat unenviable.
Hence, it carries a higher rate of interest than the primary mortgage. The loan is provided depending on the amount of built up equity on the house. The built up equity on the house is the difference between the market price of the house and the amount of mortgage payments due on the first mortgage.
In other words, a borrower should have enough equity on the house to get a second mortgage. If the equity on the house is negative, it is unlikely that the lending institution will be willing to provide a mortgage loan. The loan to value ratio is calculated by dividing the payments, due on the first and second mortgage, by the appraised value of the house.
A higher loan to value ratio is unfavorable. A traditional second mortgage is a fixed rate level payment mortgage that has to be discharged over a period of 15 or 30 years.

Home Equity Loans and Home Equity Lines of Credit

A second mortgage can be a Home Equity Loan (HEL) or a Home Equity Line of Credit (HELOC). Both HELs and HELOCs are borrowed against the built up equity on the house. The interest paid on the loans may be fully tax deductible.
However, HELOC is more flexible than HEL, since the borrower is charged interest on the amount of money that he borrows and not on the entire amount of loan available to him. In case of HELOC, this amount is not a lump sum. The borrower is given access to a line of credit that allows him to borrow money as and when required using a credit card or a check.
Interest rates, that fluctuate with the prime rate, determine the interest payments to be made on the borrowed sum. HEL has a rigid structure that forces the borrower to borrow the entire amount of money in one go and pay a fixed rate of interest on the lump sum. In other words, obtaining a HELOC is like having a credit card, while a HEL is a normal loan.

Reasons for Obtaining a Second Mortgage

HEL for Debt Consolidation

Debt consolidation refers to paying off multiple loans with a single loan having a low rate of interest. Debt consolidation may be especially useful for people who are laden with credit card debts.
Consolidation may be a successful strategy for people who are able to obtain a HEL, as a HEL has a low fixed rate of interest as compared to credit cards that carry a much higher APR (Annual Percentage Rate).

HELOC for Home Improvements

People who need money for making improvements on their home, can try to obtain a HELOC. A HELOC allows a person to avail loans as and when required and pay a floating rate of interest on the amount borrowed.

Avoiding Private Mortgage Insurance (PMI)

Private Mortgage Insurance enables a person to obtain a mortgage on a house despite paying less than 20% as down payment. A person can obtain a primary mortgage for 80% of the appraised value and a second mortgage for 15%. The remaining 5% of the value of the house is covered by the down payment.
'80-10-10' and '80-20' are the other popular ratios for home loans. Rather than paying an insurance premium on PMI, a person pays interest on the second mortgage. The choice between PMI and second mortgage depends entirely on the amount of savings that can accrue to a person.
The Making Home Affordable Plan is part of the Financial Stability Plan launched by the Obama administration. This plan has provisions for reducing the payments on second mortgages, in order to prevent foreclosures that have become rampant since the housing market crashed. Plans like these will make a second mortgage affordable to those who need it.