Taking out a second mortgage means you get a loan secured by your house on top of your first, or initial mortgage. This was once considered a desperate move by someone who couldn't keep up with debt or couldn't pay for his kids' college. However, when real estate was a gold mine, some homeowners more proactively used second mortgages to pay for major purchases. This has some financial benefits but isn't without risks to you and your property.
The phrase "second mortgage" means that you get another loan -- in addition to your mortgage -- secured by your property. Banks and lenders typically call this a home equity loan. It is a lump sum loan that you get based on the equity in your home. The bank allows you to borrow your home's equity with the caveat that if you don't pay the loan back, it has the right to foreclose or repossess the property. Lenders once doled out equity financing that made your combined first and second mortgage balances 100 percent of your home's value. A June 2010 Bankrate.com article noted creditors have been stricter since a credit market crisis that left many homeowners underwater. Some cap your combined ratio at 80 percent as of 2013.
Homeowners turn to second mortgages for several reasons. Funding college for your kids has long been a motive for tapping into home equity. Others have used equity loans to start businesses or to pay for major home renovation projects or repairs. An increasing number of homeowners are also using second mortgages to pay off credit card or personal loan debt as part of a debt consolidation move.
Relative to unsecured personal loans or credit cards, a second mortgage normally has a favorable interest rate, albeit higher than your first mortgage. By using a second mortgage for property improvements, debt consolidation and schooling, you are theoretically borrowing at a low rate to invest in things that should provide tangible financial benefit in the future. The interest on home-finance loans is also normally tax deductible. For homeowners, mortgage interest is a key deduction that lowers your tax obligation.
Homeowners have become more accepting of the risks of second mortgages, but the risks are plentiful. The most extreme risk of taking on additional home-secured financing is further extending your home as collateral on loans. The risk of using equity financing for debt consolidation is that you increase your home-financed debt, and now your credit cards are freed up for more spending. Additionally, homeowners who take on too much second mortgage financing may spend money on less essential items.
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