If you have been paying your home off for years, improved the property, or benefitted from a boom in real estate value, you may feel like you’re sitting on a gold mine without a shovel.
Compared to the outstanding balance on your mortgage, the value of your home may be $50,000, $100,000, or even more in excess of that balance. Is that value really out of reach until you sell? Could you not access that equity as cash to:
These are all valid reasons to eyeball your home equity (that is, the positive difference in what the home is worth vs. what you owe on it) and wonder if you can turn that equity into cash.
If you own something of value, lenders are usually willing to accept it as collateral for a loan—if the deal makes financial sense for both parties. One of the most obvious ways to go about this is to refinance your first mortgage. Most people understand this process because they went through it to get their first first mortgage.
Fewer people understand the intricacies of a second mortgage or a HELOC (“home equity line of credit”), but they may actually be the better options for a number of reasons. But which one to pick—second mortgage or HELOC?
Let’s first discuss why you might choose a second mortgage or HELOC instead of refinancing your first mortgage.
As you explore your options, one of the first things you will notice about second mortgages and HELOCs are the higher interest rates (we’ll discuss why that is later).
Why, then, would you choose them? Won’t your monthly payments be higher than they would be if you just refinance the first mortgage into one loan with a higher balance?
That higher balance is the reason. Loans often have closing costs proportional to the loan balance. If you owe 50% of the value of your home and want to take out a new loan at 80% of the home’s value, you might have to pay closing costs up to 3% of that big 80% balance.
By borrowing the 30% difference as a second mortgage or HELOC, you might only owe 3% of that smaller balance in fees and closing costs. Some loan products may have no fees at all. The bottom line is, you owe less money out of pocket in fees, even if your payments are a little higher.
In fact, those payments might not be higher at all. If you got your first mortgage at historically low interest rates, the market rates available on a first mortgage may be higher. A smaller loan, even at a higher interest rate, may result in lower total monthly debt service if you keep that lower-interest first mortgage.
While there are key differences between a HELOC and a second mortgage, they some have similarities as well:
The reason interest rates tend to be higher on second mortgages and HELOCs is that they are junior liens compared to the first mortgage. That means that the lienholder (lender) has fewer rights to foreclose than the senior lienholder.
If you default on your first mortgage (the “senior lien”), the first lienholder gets to foreclose on the house—even if your payments on the second mortgage are current. The collateral for the loan could be snatched out from under the second lienholder.
If you default on the second mortgage, the second lienholder can foreclose … but the senior lienholder then has the right to initiate foreclosure proceedings that trump the second lienholder’s right to foreclose. Again, the second lienholder loses the collateral.
This makes second mortgages and HELOCs inherently more risky for the second lienholder, hence the higher interest rates. The exception is when both liens are held by the same lender.
In the case of both second mortgages and HELOCs, you can expect the lender to carefully examine your personal financial statement and personal credit, including your credit scores and complete credit reports.
The lender will want to see verifiable, stable income that justifies the extra credit, plus a strong history of on-time payments on other loans and obligations and a strong “debt-to-equity” ratio.
While this isn’t always the case, in conservative credit markets, lenders do not want to work with homeowners to borrow the entire appraised value of the home. That situation would be described as a “100% loan-to-value” percentage—for example, the home is worth $300,000, and the borrower has taken out $300,000 in loans with the home as collateral.
Lenders want to see homeowners retain a certain amount of equity as a safety cushion. 20% is a common limit—that is, 80% loan-to-value. Some lenders may go as high as 85% loan-to-value, 90% loan-to-value, or higher.
Let’s say your home is appraised at $300,000 and you owe $200,000. If a lender has a loan-to-value limit of 80%, the maximum second mortgage or HELOC that lender will approve you for is $40,000. This will bring the total loans against the property to $240,000, which is 80% of the home’s appraised value.
A second mortgage or HELOC doesn’t have to be smaller than the first loan. If your first loan represents only 20% or 30% of the home’s appraised value, you could easily take out a second mortgage or HELOC that is larger than the first mortgage.
While second mortgages and HELOCs share the above characteristics in common, they differ in the following ways:
A second mortgage resembles your first mortgage in many ways. By the way, you can only have a second mortgage if there actually is a first mortgage. If the second mortgage were the only mortgage on the house, it would be the first mortgage with no lien senior to it.
In all other ways, a second mortgage resembles a first mortgage—it has an interest rate, an amortization schedule, and a loan term. This interest rate could be fixed or variable; the loan term anywhere from 15 to 30 to 40 years; the longer the amortization schedule, the lower the monthly payments, although you will pay more interest over the term of the loan.
Once the loan closes, you get the loan balance as a lump sum of cash by check or electronic transfer. When you bought the home, those loan proceeds went right to the seller; with a second mortgage, it goes to your bank account.
Whereas a second mortgage is a fixed loan, like a car loan, a HELOC is a revolving line of credit. In this way, it is more like a credit card.
A credit card has a “credit limit.” You can borrow up to that credit limit by swiping the credit card. There’s a minimum payment you have to make to avoid default penalties. If you don’t pay your balance in full, you get charged interest according to the annual percentage rate (APR).
A HELOC works in exactly the same way, only your house is the security and the size of the credit limit depends on the appraised value of the house and the lender’s loan-to-value tolerance.
Instead of getting a $40,000 check, for example, you get a $40,000 credit limit. You might get a payment card, separate checkbook, or electronic loan portal to draw against that credit limit. If you don’t pay the balance in full before the statement period ends, interest will be assessed on the remaining balance per the APR. If you pay in full, no more interest is owed.
HELOCs usually have terms, wherein you can pull out cash and repay it at will. A typical HELOC period is 10 years. After the HELOC term, there is usually a repayment period, say 20 years, where the HELOC becomes similar to a mortgage—you can’t borrow any more against the balance, and whatever balance remains must be repaid, both principal and interest, on a set amortization schedule.
Unlike a second mortgage, you can get a HELOC even if there isn’t a first mortgage. In fact, you could probably get a bigger HELOC on a home you own free-and-clear, since the loan-to-value percentage is 0%.
Do you have bad credit, low income, over-leveraged, or looking for solutions outside the conventional lending box? Are you tired of the bank bureaucracy, politics or games? With the marketplace changing and the bank’s rules becoming more stringent, it is extremely difficult working with the traditional banking solutions and it is not for everyone.