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Related to second mortgage: Home Equity Line of Credit
second mortgagea second LOAN raised by a property owner against the COLLATERAL SECURITY of his or her property See MORTGAGE.
A mortgage (or deed of trust) that is placed on property after another mortgage. Typically, the first mortgage provides security for the loan used to finance the bulk of the purchase price. The second mortgage could be seller financing for some portion of the purchase price, a home equity line of credit, construction cost overruns, or any other reason.In a foreclosure, no money can be paid to the second mortgage holder until all principal, interest, and expenses of the first mortgage have been paid in full. This results in a greater risk that the second mortgage lender might not receive payment of its debt,so it usually charges a higher interest rate than the first.
A loan with a second-priority claim against a property in the event that the borrower defaults.
Second Mortgages Versus Home Equity Lines: A second mortgage is any loan that involves a second lien on the property. Some second mortgages are for a fixed dollar amount paid out at one time, in the same way as a first mortgage. As with firsts, such seconds may be fixed rate or adjustable rate.
A home equity line of credit (HELOC) is usually a second mortgage also, but instead of being paid out at one time, it is structured as a line of credit. (They are frequently referred to as “home equity lines.”) A HELOC allows the borrower to draw an amount at any time up to some maximum. They are always adjustable rate. See HELOC.
A line of credit is most convenient when cash needs are stretched out over time. A common example is a series of home improvements, one followed by another. Fixed-dollar seconds are best when all the money is needed at one time. Many home purchasers take out such seconds to avoid mortgage insurance on the first mortgage or the higher interest rate on a jumbo loan.
When taking a fixed-dollar second, borrowers can select between fixed and adjustable rates, as they prefer. When taking a HELOC, they take an adjustable, and if they want a fixed they can refinance into a fixed-dollar second after they have drawn as much as they intend to borrow on the line.
Seconds Priced Higher than Firsts: Second mortgages are riskier to lenders than first mortgages. In the event of default, the second mortgage lender gets repaid only if there is something left after the first lender is fully repaid. Hence, the rate will be higher on the second, provided everything else (mortgage and property type, borrower credit, etc.) is the same. Of course, if the second mortgage is a line of credit with an adjustable rate, it may well be priced below the rate on a first mortgage with a fixed rate.
Refinancing a First with a Second: As a general rule, it is not a good idea to take out a second to pay off a first, because seconds are priced higher. If you take out a second mortgage to repay the first, the second becomes the first, which is a gift to the lender: you are paying a second mortgage price on a first mortgage.
But there is at least one exception to this rule. Borrowers with a high-rate first mortgage with a small balance may find it more advantageous to pay off the first with a second rather than refinance the first. This reflects the higher settlement costs on the first.
Some borrowers lower their rate by refinancing a first with a HELOC. In the process, however, they are exposing themselves to the risk of future rate increases. HELOCs are much more exposed than standard ARMs.
Using a Second to Avoid Mortgage Insurance: Borrowers who put down less than 20% on a first mortgage usually must purchase mortgage insurance. However, a borrower can take an 80% first mortgage combined with a 5%, 10%, or 15% second mortgage, and avoid mortgage insurance. Such combination loans are referred to as 80/5/15s, 80/10/10s, and 80/15/5s. An 80/15/5 is an 80% first, 15% second, and 5% down.
Whether a combination loan saves the borrower money depends on a variety of factors. For example, a combination loan is more advantageous than a single loan with mortgage insurance the smaller the difference in interest rate between the two mortgages, the shorter the term on the second mortgage relative to the term on the first, and the higher your income tax bracket.
These and other factors affecting the costs of both options are pulled together in calculator 13a on my Web site. The calculator shows all the costs of both options over any future period, and the “break-even rate” on the second mortgage, which is the highest rate it makes sense to pay. The combination loan will save you money if the market rate on the second is below the break-even rate.
Using a Second to Avoid Jumbos: Jumbo loans are larger than the maximum size loan that Fannie Mae and Freddie Mac can purchase. In 2003, the maximum was $322,700. Jumbos carry interest rates from 1/4% to 1/2% higher than the “conforming” loans purchased by the agencies.
Borrowers who need a loan above the conforming loan maximum, but not too much above it, may save money by taking a first mortgage for the maximum and a second for the amount required above the maximum. Calculator 13a can be used to determine whether a conforming loan plus a second will be less costly than a jumbo.
Second Mortgage Versus Cash-Out Refinance:
Second Mortgage Versus 401(k) Loan: Many borrowers have the choice of borrowing on a second mortgage or borrowing against their 401(k) plan. Several factors bear on this decision.
Relative Interest Cost: The general rule is that you select the one offering the lowest after-tax cost. On a second mortgage, the after-tax cost is the interest rate less the tax savings. You can calculate this by multiplying the interest rate by one minus your tax rate. For example, if the rate on a home equity loan is 8.5% and you are in the 28% tax bracket, the after-tax cost is 8.5 x (1 - .28) or 6.12%.
The cost of borrowing from your 401(k) is not the rate you charge yourself because that goes from one pocket to another. The cost is what your loan would have earned had you kept the money in the 401(k). This is sometimes called an “opportunity cost.” Since your 401(k) accumulates tax free, the total return on the fund is a close approximation of the after-tax cost.
Of course, taxes must eventually be paid on the earnings on your 401(k). But this doesn't happen until you retire, and even then the tax payments will be stretched out over time unless you elect to withdraw a lump sum.
Consequences of Unemployment: The two fund sources have different consequences should you be laid off. Unless the 401K loan is repaid within a month or two of losing your job, it is considered by the IRS as a taxable distribution on which income taxes, and perhaps a 10% early withdrawal penalty, are due. A second mortgage loan need not be repaid if you are laid off. On the other hand, you must continue making the payments on the second mortgage or risk losing your home.
Some other possible negative consequences of second mortgages that borrowers should factor into their decision are discussed immediately below.
Loss of Flexibility from Negative Equity: A second mortgage reduces the equity in your house, in some cases converting positive equity to negative equity. Borrowers with negative equity lose flexibility. It becomes difficult or impossible to refinance should a favorable opportunity to do so arise, and it may also be impossible to sell. Second mortgages cannot be transferred to a new house. The sale requires that all liens be paid off, so if the liens add up to more than the house is worth, the seller must come up with the needed cash.
Subordination by Second Mortgage Lender: A borrower with a second mortgage can't refinance the first mortgage unless either the second is refinanced as well or the second mortgage lender agrees to allow it by signing a subordination agreement. Without such an agreement, paying off the first mortgage automatically converts the second mortgage into a first mortgage and any new mortgage would become a second.
The problem is that second mortgage lenders have varying policies toward subordination. Some will do it for a modest fee. Some will do it subject to conditions, such as that any new first mortgage not be cash-out, which would weaken the second mortgage. And some won't do it at all! Lenders' policies toward subordination are not a required disclosure, and very few borrowers find out what their lender's policy is until they try to refinance their first mortgage.
If you do take a second mortgage, ask the lender about its subordination policy immediately after asking about the interest rate. If the lender doesn't allow subordination, march out the door. There's another second mortgage lender down the street. If they say they do allow it, ask about any conditions, if there is a fee, and how long it will take. If the answers are satisfactory, get it in writing and make sure it is incorporated in the loan documents so that if the loan is sold the new lender will be bound by it.
Negative Amortization ARM May Prevent a Second Mortgage:
Mortgage lenders may be unwilling to make a second mortgage loan if the first mortgage is an ARM that allows negative amortization.
Second mortgage lenders assess the risk on a second by the amount of equity available to pay them. The equity equals the property value less the balance on the first mortgage. Since the loan balance on the great majority of first mortgages goes down every month, the equity available for the second rises every month.
But a negative amortization ARM is a different story. On these loans, the balance can rise over time, which reduces the equity protecting the second mortgage. Some lenders will reject second mortgage
applications out of hand when the first is a negative amortization ARM, without considering whether or not the equity protecting them might be adequate.
For example, I ran into a case where the balance on the negative amortization ARM was only 60% of the current property value and could not rise by more than 25% in a worst case. This would bring it to 75% of current value in a worst case. The application was rejected, although the same lender would make seconds in cases where the balance on a FRM was 80% or even higher. The lender heard the dreaded words “negative amortization” and shut its ears.