Image courtesy of Flickr, Simon Fraser University
A second mortgage can be an important financial tool in specific situations. However, it is important to understand exactly what it is so you can make sure you are using this tool wisely.
The concept of a second mortgage is intriguing, but a little scary. In some cases, it can be a beneficial way to get the cash you need to improve your home. In other cases it can be used to combine with a first mortgage in order to purchase a home. However, if you do not utilize it properly, it can be a quick way to get in over your head financially.
Learn more about this tool so you can decide if a second mortgage is a wise choice for your needs.
A second mortgage is a type of financing that is made on a property while the first/primary mortgage is still in place, or in combination with a first mortgage when purchasing a new property.
If a property is foreclosed on by a lender, the first mortgage will get paid off first and if there is anything left over, the second mortgage will get paid off next. Therefore the risk to the lender issuing a second mortgage is higher.
Second loans are riskier for lenders because in event of a default it is only paid off AFTER the first loan is paid off, so a second mortgage is usually for a significantly smaller amount and for a higher interest rate.
Since a second mortgage is usually for a smaller amount and a higher interest rate, why would a borrower choose to obtain a second mortgage?
There are actually two distinct times when such a loan is necessary-during the initial purchase OR during a refinance:
One reason many people choose a second mortgage is because they cannot get a single loan for the amount they need to purchase a home. Sometimes getting a first mortgage and then a smaller, supplementary mortgage will help you to be able to purchase a home you could not otherwise qualify to buy. Another reason you might obtain this loan during purchase is if the house needs significant repairs or upgrades in excess of the purchase price.
When you refinance a home, often a second mortgage is chosen to help you access equity in your home. This can allow you to take care of necessary repairs or pay off other higher interest rate loans, such as a business loan or personal loan.
Like any type of mortgage, the credit requirements of a second mortgage may vary from case to case. There are no certain credit score requirements to obtain a second mortgage. However, you will often find that getting your score above 600 and ideally 650 is what it takes to get lenders to approve you for a loan that won't have a higher interest rate than you may be comfortable paying.
The document requirements of a second mortgage should be quite simple for you, assuming you already have the first mortgage. You will usually need the same type of documentation as a first mortgage. Most lenders will require that you prove ownership of the home and give some documentation about your income and ability to repay the loan.
The best way to see how a second mortgage will affect you personally is see how your payments will work. A simple example would be:
The main advantage of a second mortgage is that it allows you access to money you may not otherwise be able to obtain. If you are using the money to improve your home or pay off higher interest rate loans, it makes perfect sense to choose this type of financing and improve your overall financial picture.
Another advantage is that you do not need to refinance your first, primary mortgage if you are looking to cash out. Many people have a very low rate with a good term on their existing loan, so a second mortgage gives you the opportunity to tap into your equity without touching your first mortgage.
The disadvantages of second mortgages occur when you borrow more than you are able to pay in the future and end up getting your finances into a difficult place. If your home loses value, a second mortgage could make it harder to get back to a comfortable place financially because you will not have the ability to refinance and consolidate your two mortgage together.
Additionally, there are closing costs associated with this type of loan, so you must be careful of the added expenses as well.
A second mortgage is a useful tool for some homeowners, but it isn't always the perfect solution. You should be aware of the credit and document requirements before you apply for a second loan. Also make sure you learn more about the process and costs involved before you dive in. You will be more likely to make a smart borrowing decision when you know exactly what you are getting into, so there is no reason to rush to judgment.
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