What is a second mortgage?: How it works

second mortgage

A second mortgage or junior-lien is a loan you take out using your home as collateral, while you still have another loan on your home. 

Home equity loans and home equity lines of credit are common examples of second mortgages. Some second mortgages are “open” (meaning you can continue to withdraw cash up to the maximum amount of the credit and, as you pay off the balance, you can withdraw again up to the same limit) and other second mortgages are “closed” (in which you receive the full amount of the loan in advance and cannot withdraw it again).

The term “second” means that if you can no longer pay your mortgages and your home is sold to pay off debts, this loan is paid second. If there is not enough equity to pay off both loans in full, the second mortgage lender cannot collect the full amount owed. As a result, second mortgage loans often have higher interest rates than first mortgage loans.

Taking out a second mortgage will increase your total debt load. Every time your total debt load increases, you make yourself more vulnerable should you experience financial difficulties that affect your ability to pay your debts. You need to know that home equity loans or home equity lines of credit are very risky, if you cannot pay, you could potentially lose your home since you are using its value as collateral.

Be careful when using home equity to consolidate higher-interest debt. 

When you use home equity to pay off other debts, you’re not paying them off. You are simply using one loan to pay off another. Interest rates may be lower in the short term, but that’s only because you’re using your home as collateral. The risk is that if you can’t pay the home equity loan, you could lose your home.

Also, if you take on more debt, it could make it harder to pay off that new debt and current loans. For example, taking out a mortgage to pay off a five-year car loan may have you making payments and paying additional interest for ten, fifteen, or thirty years. Be careful about exchanging short-term debt for long-term debt, at a higher cost to you.

Why are second mortgages risky?

Before taking out a second mortgage, it’s important to consider the downsides of getting one. Ultimately, you will have to pay back the funds you borrowed. Because your home acts as your collateral (meaning it secures your loan), the lender can force you to foreclose on your home if you default on your second mortgage.

Second mortgages are subordinate to primary mortgages, so if you default on your loans, your first mortgage debt is paid off before the second mortgage lender receives anything.

For that reason, home equity loans and HELOCs are considered riskier than traditional mortgage loans. Therefore, they typically have higher interest rates.

In addition to higher mortgage rates, there are additional fees you’ll owe if you want a second mortgage. Closing costs on second mortgages can be 3% to 6% of your loan balance.

If you’re planning to refinance, having a second mortgage can make the entire process more difficult to navigate.

Home equity loan payments are generally easier to manage because you can set your budget knowing you’ll pay x amount of money each month for that second home loan.

However, since the amount you owe for a HELOC will vary, you may not be able to pay your bill if it is significantly more expensive than it was previously. And if you need a second mortgage to pay off existing debt, that extra loan could hurt your credit score and you could be stuck making payments to your lenders for years.

Are there income tax benefits to getting a second mortgage payment?

Second mortgages on the same property generally do not carry any special income tax benefits. However, if you take out a second mortgage on a new property, you will generally be allowed to deduct the interest on your first and second homes.

By aamritri

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