What Is the Purpose of a Second Mortgage?

People use second mortgages to cash out home equity.

People use second mortgages to cash out home equity.

You can use a second mortgage to finance any legal activity, although many people use these loans to fund home repairs and maintenance. If you have an existing mortgage, you may consider refinancing that loan to cash out more equity rather than taking on a second mortgage. However, financing restrictions mean that you can't always refinance your home with a single loan, even if you have some equity in it. Additionally, many people use second mortgages as low-cost alternatives to other types of consumer loans.

Loan To Value

A mortgage is a secured debt, which means that the lender can foreclose on your home if you fail to pay off the loan. Government-sponsored mortgage firms Freddie Mac and Fannie Mae buy most of the mortgages that originate in the United States. These entities impose loan-to-value limits on lenders that cap the percentage of a property that a lender can finance with a single loan. On some types of loans, Fannie Mae and Freddie Mac allow lenders to finance only 70 or 80 percent of the property value with a first-lien loan. This means these firms have more room to maneuver if a foreclosure sale fails to raise enough cash to settle the debt. Some banks use second mortgages as a mechanism to offer borrowers 100 percent financing by issuing second-lien loans alongside first mortgages.

Private Mortgage Insurance

While some mortgage firms enable you to finance up to 100 percent of your home with a single loan, these firms typically require you to buy private mortgage insurance if your first mortgage exceeds 80 percent of the property value. The mortgage insurance covers some of the lenders losses if you default on the loan. Legally, your lender cannot require you to buy PMI if your first mortgage amounts to less than 80 percent of your home's value. Therefore, you can extract equity from your home without paying PMI if you just take out a second lien alongside your existing mortgage.

Risk

Most lenders used risk-based pricing when issuing loans, which means that the riskier the loan, the higher your interest rate. Credit cards and personal loans tend to have the highest rates, since these debts are unsecured -- your lender has very little recourse if you default on the debt. Vehicle loans usually have lower rates than credit cards because of the collateral, but the term times are limited because vehicles have only a limited lifespan. If you need a long-term loan and a low rate, a second home loan may represent your best option because homes have a longer shelf life than vehicles, and these loans provide the bank with some collateral.

Flexibility

Second mortgages appeal to many homeowners because of the flexible loans available from lenders. With term times ranging from five to 30 years, you can find a second mortgage payment to suit your income level. If you like the flexibility of making interest-only payments, you can take out a second-mortgage line of credit, which works like a credit card. If you prefer having fixed payments, take out a second-mortgage installment loan, in which case you receive a lump sum at closing and then make monthly fixed principal and interest payments for the duration of the loan term. If you have a reasonably high credit score, reliable income and some equity in your home, you can find a second mortgage product that meets your needs.

About the Author

Ciaran John began writing in 1994 with contributions to "The Hourly Press" and "The Sawbridgeworth Observer," and has since written for many online and print publications. He has 12 years experience working for financial services companies as a business banker, lender and investment representative and spent four years working in human resources.

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