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, COMMERCIAL, AND ALTERNATIVE LENDING

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.

Whatever the case there is an alternative here for you!