Second Mortgage vs. HELOC: What’s the Difference, and Which Should I Get?

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:

  • Consolidate higher-interest debt like student loans or credit cards into a lower payment?
  • Perform repairs and improvements on the home that might increase the value even more?
  • Check items off your bucket list, like a career sabbatical, dream vacation, or lessons in a new skill, while you’re still in your prime?

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?

Why Not Refinance Your First Mortgage?

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.

Similarities Between a Second Mortgage and a HELOC

While there are key differences between a HELOC and a second mortgage, they some have similarities as well:

Junior Liens

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.

The Importance of Personal Credit

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.

The Loan-to-Value 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.

Differences Between a Second Mortgage and a HELOC

While second mortgages and HELOCs share the above characteristics in common, they differ in the following ways:

Second Mortgage: Fixed Loan

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.

Reasons to Choose a Second Mortgage

  • Consolidate high-interest debt.
  • One-time expenses like home improvements or a major repair.
  • One-time events like a career sabbatical or wedding.

HELOC: Revolving Line of Credit

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%.

Reasons to Choose a HELOC

  • Ongoing home maintenance that will preserve and increase the home’s value.
  • Create a “financial cushion” for emergency liquidity.
  • “Lifestyle financing” like annual vacations.

3 Alternative Financing Options Worth Considering

Most homeowners understand the concept of a home mortgage. In fact, a recent study by researcher Sharanjit Uppal found that between “1999 to 2016 the median amount of mortgage debt among Canadian families with a mortgage almost doubled1.”

Data shows, as well as through popular belief, that a traditional mortgage is the main way to purchase a new home. But did you know there are other ways you can finance the purchase of a new home?

Alternative financing options have gained some traction in recent years. Buyers are finding that underwriting and eligibility requirements for new mortgage financing are becoming increasingly rigorous, especially amidst the COVID-19 pandemic.

New lending standards may be a barrier to entry for new buyers looking to penetrate the housing market but may not meet the new credit or income eligibility criteria.

Conversely, other financing solutions may offer a solution to this segment of borrowers looking for a new home loan.

Here are three alternative financing options to consider when you are reviewing your financing options.

Installment Land Contracts

Are you looking to purchase a new home but you know your credit or income may not meet the standard guidelines for a mortgage through a traditional lender? An installment land contract may be the solution to your needs.

An installment land contract is an agreement with the seller of a property to provide financing to you, the buyer, without you having to obtain a loan through a normal financial institution. The seller will convey to you the right to possess the property and in return you will pay the seller a monthly installment payment for the purchase.

A portion of the installment payment is typically structured to go both towards the principle balance owed, as well as accrued interest. The seller retains legal title of the property until the agreement is paid off2. After the payoff, the deed is then recorded and full ownership transferred to the purchaser.

One downside to an installment contract, at least for a seller, is that if a buyer defaults on the agreement, there aren’t as many, if any, protections coinciding with foreclosure.

However, provisions can be built into the agreement regarding a breach of contract by the buyer for failure to make payments2. In this scenario, the seller would most likely regain possession of the subject real estate and retain any previously paid installment payments2.

Rent-to-Own or Lease-to-Own Programs

As home prices continue to increase and are expected to increase by just over 3% in 2020, new buyers looking to enter the housing market may find it burdening to come up with heftier down payments that are typical with conventional mortgage financing4.

To combat this trend, borrowers have been increasingly turning to rent-to-own or lease-to-own purchase programs. Unlike a traditional purchase transaction, a rent-to-own plan allows you to rent a new home for a period of time, at which point once the agreement has been fulfilled, you have the option to purchase the real estate outright, through traditional or other means.

While there are costs and fees associated with choosing a rent-to-own plan and a smaller down payment may be required up front. However, in many cases, a portion of your monthly payment goes toward an additional savings component which is later added to the initial down payment and used against the future purchase price should you exercise the option to purchase the home down the road.

One downside with a rent-to-own plan is that buyers must absorb additional risk. While they can save for their purchase over time, if a property owner gets foreclosed on, you lose the option to purchase in your current agreement and have to work with the foreclosing bank to purchase the property.

Private Mortgage Lending and Hard-Money Loans

Another way to borrow money without going through a traditional lender, such as a bank or credit union, is by utilizing a private money lender. Private money lenders are usually investors or individuals who will lend money using your home as collateral.

While private lenders usually require less documentation than a traditional lender, that does not mean they will write any loan. Hard money lenders still complete due diligence to make sure you can repay the debt; however, they may look at other compensating factors rather than a narrow review of your credit request.

For example, a hard money lender may care more about your general history of borrowing and being able to repay your debts, as opposed to your physical credit score.

Although hard money loans are an option, you’ll still need to have healthy finances. If you don’t have a healthy financial picture, you can still get a loan, but you’ll expect to pay much higher premiums to offset the investor or individual lender’s risk in the transaction.

You should also expect to have some skin in the game, meaning that you may have to put a sizable amount of money down. This is not always a requirement for all private lenders. We at Freedom Capital can help you acquire financing even in the most challenging situations.

If you’re interesting in acquiring financing, contact us today to discuss your goals and alternative financing needs. Click here to explore our alternative financing products. 

Sources

1 Uppal, S. (2019, August 08). Homeownership, mortgage debt and types of mortgage among Canadian families. Retrieved from https://www150.statcan.gc.ca/n1/pub/75-006-x/2019001/article/00012-eng.htm

2 Practical Law – Installment Land Contracts. (n.d.). Retrieved July 6, 2020, from https://ca.practicallaw.thomsonreuters.com/6-511-8789?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1

3 Pritchard, J. (n.d.). Pros and Cons of Hard Money Loans. Retrieved July 6, 2020, from https://www.thebalance.com/hard-money-basics-315413

4 Services, R. L. (2020, January 09). Canadians can expect a vibrant spring real estate market, with home prices rising modestly. Retrieved July 6, 2020, from https://www.newswire.ca/news-releases/canadians-can-expect-a-vibrant-spring-real-estate-market-with-home-prices-rising-modestly-884135807.html#:~:text= According to the Royal LePage Market Survey Forecast, released in, in 2020, rising to $669,800.

How to Use a Second Mortgage to Consolidate Debt

Households are continuously trying to adapt to the shifting environments brought about the by COVID-19 pandemic. In the wake of unemployment and volatile financial markets, balancing a household budget sometimes means tapping into reserve savings or purchasing certain household necessities using a consumer credit card.But stacking up more and more credit card debt or taking out new personal loans may seem like the perfect short-term solution to your household liquidity troubles, but they can spell disaster in the long run.The better alternative for homeowners to consider is to consolidate those high-interest credit cards into an affordable financial vehicle, leveraging a stable and durable asset.

Many borrowers don’t realize that, with enough equity, you can take out a second mortgage on your home to pay off and consolidate costlier consumer debt. You may even elect to take cash out for other purposes to take advantage of other financial opportunities.

Taking out a new second mortgage can be a smart decision. Let’s take a look at what a second mortgage is, how it works, and what sorts of benefits it can provide.

What is a Second Mortgage?

A second mortgage is a popular financing tool that allows a homeowner to utilize the equity in their home for a variety of purposes. Much like a first mortgage, the lender places a lien on your home to secure the debt. This could be junior to an existing mortgage or in first position if the property is owned free and clear.

The term second mortgage is used fairly loosely but is often referred to by most as a fully amortized term loan. But in actuality, a home equity line of credit could just as easily be classified as a second mortgage, although it operates differently than a traditional term loan.

Second mortgages can come with a variety of repayment options. Borrowers can choose from fixed-rate or adjustable-rate solutions, fully amortized term loans, or even a revolving line of credit. It’s important to review your financing goals to determine which second mortgage financing solution might be best to fit your particular needs.

How Does a Second Mortgage Work?

Much like a first mortgage, lenders will allow you to borrower up to a certain amount based on the value of your home. Generally, you can borrow up to 80% of your home’s appraised value1.

A simple example would be that if your home is worth $100,000, you can borrow up to $80,000. The thing to remember is that if you have a first mortgage, that has already eaten up a portion of the equity accessible through a second mortgage.

Using the same example, if you owe $50,000 on your first mortgage, you are left with only $30,000 available for second mortgage financing.

While some lenders in larger cities or private money lenders may allow you to borrow a larger percentage of what your home is worth, keep in mind highly leveraged properties carry with them more risk1. Lenders may charge a higher premium in the form of additional costs or a higher interest rate to offset that additional risk.

Another thing to note is that just because you have available equity in your home doesn’t mean you automatically qualify for financing. You still have to submit a loan application, which involves a credit check, as well as an income analysis and verification1.

Lenders will also want to verify the value of your home through an appraisal. You may also have to pay the associated application and processing costs for the new loan. Consider all the costs that are involved with getting a second mortgage, including but not limited to, appraisal fees, title fees, recording fees, and other applicable origination costs1.

Term Loan vs Home Equity Line of Credit (HELOC)

When using a second mortgage to pay off other credit cards or high interest debt, it’s important to understand your product options. Generally, the two options lenders will provide are a fully amortized term loan or a home equity line of credit. Both options have their own sets of advantages and disadvantages.

Comparing the two, a fully amortized term loan pays you a lump sum of cash that you can then use to pay off your other debt. What’s nice about this option is that from your first payment, your payment will go towards both the principal balance and accrued interest. After your final payment and the loan is paid in full, it goes away and the lien on your home is satisfied.

However, with a term loan you cannot draw any additional money once you close on the loan. You would either need to refinance or take out another loan, which can make this option less flexible.

Conversely, a home equity line of credit is nice because it provides you with an open line of credit to draw on whenever you need it. In cases where you are paying off other debts, you can pay off exactly the amounts owed and not have to worry about making up any shortages (if any).

Generally speaking, a home equity line of credit is also more flexible in that as you pay down the principal balance, it frees up your credit limit if you need to draw on those funds again in the future over the term of the loan.

Additionally, a home equity line of credit usually requires an interest only payment. This is nice during periods where money may be tighter. Keep in mind that no portion of your payment is going to pay down the principal balance of your loan. If you only make the minimum payment, you will still have a balance when your line of credit matures, at which time it will need to be renewed or paid in full.
Summary
Taking out a second mortgage to consolidate and pay off other consumer debt is certainly a great option. Not only does it make it easier to manage one payment, it may provide you a more favorable interest rate and get you on the road to enhanced financial stability.

A recent article from Business Insider notes that nationally, Canadian residential real estate debt has increased by around $238 billion2. Both term loans and home equity lines of credit are popular financing solutions.

Now more than ever, Canadians are looking for financial relief as 78% of the country remains either unsure or pessimistic about the current state of the economy3. A second mortgage could provide additional short-term financial stability during this period of economic uncertainty.

Long-term it is important to stick to your repayment plan or else risk the potential of racking up more and more consumer debt. The Canadian Press recently announced that household debt recently reached 177% of disposable income4.

Sources

1 Canada, F. C. (2019, September 09). Government of Canada. Retrieved July 6, 2020, from https://www.canada.ca/en/financial-consumer-agency/services/mortgages/borrow-home-equity.html

2 Wong, D. (2018, April 22). Canadians are borrowing against their homes in record numbers. Retrieved July 6, 2020, from https://www.businessinsider.com/canadians-are-borrowing-against-their-homes-in-record-numbers-2018-4

3 About the author(s) Marilyne Crépeau is a consultant in McKinsey’s Montreal office. (n.d.). Survey: Canadian consumer sentiment during the coronavirus crisis. Retrieved July 6, 2020, from https://www.mckinsey.com/business-functions/marketing-and-sales/our-insights/survey-canadian-consumer-sentiment-during-the-coronavirus-crisis#

4. Staff. (2020, June 12). Canadians’ household debt now 177% of disposable income. Retrieved July 6, 2020, from https://globalnews.ca/news/7058667/canada-household-debt-177/

 

Private Lending vs Bank Lending

You need access to financing.

But you’re confused about private lending vs bank lending.

So, which is better for you or your business? Do you go for a loan from your bank or a private lender?

Before deciding on which lending method works best for you or your business, it’s essential to understand the difference between bank lending and private lending.

Let’s get started.

What is a private lender?

A private lender is an individual or company that loans money.

The individual or company is not a bank.

It means borrowing money from individual investors. For example, real estate investors use private money lenders to finance projects that either don’t qualify for a traditional loan or can’t wait for the usual 30 days that a traditional mortgage lender requires for approval.

The money is secured by property with the objective of real estate financing.

Private money lenders are more relationship-based than bank lenders.

Are private lenders better than banks?

Banks charge lower interest rates than private lenders because private lenders get funds from investors looking for a decent return.

Private lenders can also get funds from other banks and financial institutions and can be flexible in funding a deal.

While each of these methods is viable, any investor should know the difference between them.

Banks are traditionally less expensive, but they are harder to get approvals for.

Private lenders, on the other hand, are more flexible and responsive.

Let’s look at it in detail.

What interest rates do private lenders charge?

Private lenders often charge slightly higher interest rates compared to banks.

However, banks are subject to strict government regulations which often dictate the kinds of borrowers and businesses they can lend to and how borrower profiles should look like.

It means banks are less flexible, and the approval process is slower because of the stringent due diligence requirements.

While private lenders are still subject to government laws, they are significantly less regulated. It means they are more flexible in their type of lending and borrower profiles.

Private lenders use a more common-sense approach to understanding issues and overcoming them.

They are more creative and investigative in qualifying borrowers and may be willing to overlook some background flaws upon valid explanation.

It means loan options are more customizable to your needs.

Do private money lenders check credit?

Unlike bank lenders, private money lenders hardly check borrowers’ credit scores. However, that doesn’t mean they don’t check at all before lending. Instead, they base their decision primarily on the asset at hand.

That said, some private lenders would also like to know who they’re lending to, and checking your credit score is one way they carry out their due diligence.

Although, not all private lenders check borrowers’ credit scores, only the more diligent lenders do.

What if you don’t have a credit or have bad credit?

Can you get a private loan with bad credit?

You have two options for a private loan if you have bad credit or no credit.

Get a private loan from the few private lenders that don’t have the credit or cosigner requirements. We at Freedom Capital assess mortgage applications by examining your equity and overall financial picture. While credit can be a part of this picture, it is not the whole story to us. We understand that you have previously dealt with financial issues, but that you have now moved beyond them.

If you are still having financial difficulties, it is still possible to acquire financing but you may have slightly higher premiums as you have a more high-risk situation.

Alternatively, get a private loan with a co-signer who has good credit.

Always discuss this challenge with your private lender.

Where can I find private money lenders?

Do you need access to immediate funds to make a new purchase, manage cashflow, or to invest in your business?

Has the bank declined your application because you have bad credit, you’re over-leveraged, or you are self-employed?

Don’t let the bank bureaucracy kill your dreams.

Freedom Capital private lending caters to individual borrower’s needs.

We make it easy and fast for you to access funding, even in the most challenging situations, while providing sound advice every step of the way.

How can I get a private loan as an investor?

While there are many private lenders out there, funding your project can still be a challenge.

If you want to speed up the process and pay lower premiums, then you’ll have to prepare and have the right mindset.

Here are some basics:

Understand private lending

You’ll need to do your due diligence and understand the facts about your project or purchase.

Facts include the security of the investment, and if it is well researched and achievable? What are the risks involved? Etc.

Lenders pay attention to the amount of equity you have invested in the property.

  1. Network and build strong relationships 

Relationship building is essential in private lending. You should trust the lender you choose and be comfortable working with them.

If you’re getting started in real estate investment, then you’ll need to make connections with every professional role in the industry such as agents, investors, attorneys, and private lenders.

  1. Make a persuasive presentation to share during your pitch.

If you’re reaching out to individual private lenders/investors directly, then you’ll need a strong presentation to separate you from your competition.

In your presentation, include your company overview, such as your education, past deals, goals, and what makes your deal the best.

You may include videos that outline previous projects you have worked with and successes.

Also, prepare for any questions that may come your way during the pitch.

Remember, the main objective here is to demonstrate that your project is low-risk and to create a good impression while highlighting your strengths.

  1. Identify the right lender for your business.

Pitching individual lenders is hard work, so you want to make sure you choose the right investor.

First, ask them about their loan terms, interest rates, and fees.

It will help you figure out how long it will take you to pay the loan back and how quickly it accrues.

Do they charge fees upfront or charge in the form of penalties? What’s the disbursement schedule? These are some areas you should seek clarification on.

Based on this information, you should choose a private lender that is the best fit for your project.

  1. Wow the investor with your pitch.

Closing a deal with a private lender goes beyond explaining the numbers.

You need to wow them with your pitch, put them at ease, and make sure both of you are on the same page.

In establishing a good rapport, initial pitching should be focused on educating a potential investor about the project and demonstrating your commitment to it.

Keep building the relationship step by step and focus on answering any questions or objections that come up.

 

How Freedom Capital can help you acquire financing.

Freedom Capital deals with over 50 institutional & private lenders. These include pension funds, life insurance companies, private investors, banks and trust companies, credit unions, pension funds, and life insurance companies.

With our extensive network of lenders, we can help you secure an approval for a private financing loan in as little as 48 hours. Our expertise allows us to obtain a lower rate and better terms for you than if you do the full process on your own. Apply or call us today at

 

Private Lending Summary

When working with private lenders, your goal shouldn’t solely focus on landing a deal and moving on.

Instead, seek a private lender you can present deals to on a long-term basis.

It means building a healthy relationship, where you can secure financing for both current and future investments.

Be professional in your networking, build a strong portfolio, and make great pitches to each lender you work with.

If you would like our help, you’ll always have options anytime you need a private loan.