Ten Things to Know About Second Mortgages
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If you own your home and need to cover a big expense — perhaps to renovate your kitchen or repair a leaky roof — but you don’t have the funds readily available, you might consider taking out a second mortgage to get the money quickly.
There are two types of second mortgages: home equity loans and home equity lines of credit (HELOCs). Although the loan types are not identical, both involve borrowing money based on your home’s equity, which is the difference between what your home could sell for in today’s market and what you still owe on your mortgage.
If you’re considering this kind of loan, there are a few things you should know:
1. Home equity loans and HELOCs are different. Although some people use these terms interchangeably, they’re actually slightly different. With a home equity loan, you’ll get the entire loan amount up front, giving you the flexibility to pay for something large all at once. A HELOC, on the other hand, works more like a credit card where the lender offers you an amount from which you can draw as needed to pay for things.
2. With either type of second mortgage, you can use the money for whatever you want. Although home equity loans and HELOCs use your home as collateral, you are not obligated to spend the money on home expenses. Many people take out home equity loans for things like college tuition, medical bills or debt consolidation. The interest rate on these loans is often lower than the rates you’ll pay on other kinds of debt, so they also can be used to consolidate higher-interest forms of debt, such as credit card balances.
3. Under the right circumstances, the interest you pay on either type of second mortgage is tax-deductible. While it’s true that you can use a second mortgage to pay for any expense, the interest on these funds becomes tax-deductible if you use it to make improvements to the home used to secure the loan. Generally, provided the money is going toward renovations or other home improvements, you can deduct the interest you pay on the loan from your federal taxes. Consult IRS guidelines on home equity loans and HELOCs for more detailed information pertaining to your unique situation.
4. The amount you can borrow is limited. The amount you can borrow for a second mortgage is tied to your home’s equity. However, in most cases, you can’t actually borrow against all of your equity. Instead, your borrowing power will usually be 80 to 85 percent of the equity in your home. That means 80 to 85 percent of your home’s market value minus any money you still owe on your first mortgage.
5. Your credit scores will have an effect on your loan terms. Know your credit scores before you start applying for a second mortgage. As with other loans, lenders look at your credit scores as one factor when determining whether to approve you for a loan and under what terms. If you have a history of missing payments on other credit accounts, lenders may see you as a high-risk borrower and be unwilling to approve you for a loan with the best terms available.
6. You’ll have to pay fees on your second mortgage. In general, these fees will be similar to those you paid for your first mortgage, although the exact amounts differ from lender to lender. The most common fees include:
- Appraisal fee, which is paid to the appraiser of your bank’s choice to determine the fair market value and the potential sale price of your home
- Origination fee, which is charged by the lender to cover administrative costs related to processing the loan
- Title fee, which is paid to a title company for researching the deed to your home and its property records
- Closing fee, which is often paid to the title company or an attorney for conducting the closing on the transaction
Other possible costs include a credit report fee, survey fees, transfer fees, attorney fees, fees for a natural hazard disclosure report, flood determination and loan insurance coverage, document courier fees and title insurance.
Pay attention to these fees and how you pay them. If they’re added to your loan amount instead of being paid up front, you’ll actually spend more in the long run in the form of interest on the total loan amount.
7. You’re putting your house up as collateral. If you borrow money against your home and don’t pay it back, the lender could foreclose on your home to pay back the debt. That’s why, if you’re using a second mortgage to pay off credit card debt, you have to be careful not to overextend yourself. You don’t want to end up losing your home and still owe credit card debt.
8. You should shop around. As with other kinds of loans and lines of credit, multiple lenders offer home equity loans and HELOCs. These include mortgage companies, banks, credit unions and savings and loan companies. Compare fees and interest rates from several lenders to determine the overall cost of each loan, and compare the terms. This will help you decide which lender is right for you. Some banks may offer “specials” in the form of waiving their closing costs or consolidating them into one flat fee.
9. You can generally cancel second mortgage agreements within three days. If you decide after you’ve signed on the dotted line that you no longer want the home equity loan or HELOC, federal law allows you to cancel it without penalty within three business days of signing. If you decide to cancel, you have to do so in writing, with your written notice postmarked or delivered electronically before midnight on the third business day. If you cancel within this amount of time, you’re generally not liable for any part of the contract or any fees.
10. Be aware of home loan scams. Some homeowners, particularly older individuals or those with credit problems, may find themselves targeted by lenders peddling unfair or unlawful loans. Common home loan scams include:
- Lenders that add insurance products you may not need to your loan
- Lenders that want you to refinance your loan often, which involves additional fees and could mean paying more interest
- Lenders that offer favorable loan terms initially but then try to charge higher fees or offer worse terms when it comes time to sign
- Lenders that don’t take the time to review your financial status to be sure you can actually repay the loan
- Lenders that charge fees not allowed by law
Second mortgages can be excellent ways to fund large purchases. But before you invest in a home equity loan or HELOC, just make sure you’re aware of how such a commitment could impact your finances.