It's amazing how many people get confused between a second mortgage and a home equity loan. For all intents and purposes they are one and the same.
The amount that can be borrowed on a second mortgage is based on the difference between your home's current value and the outstanding principal balance on your first mortgage - this is known as your 'equity' - starting to sound familiar? Additionally in the U.S. the interest paid on a second mortgage is normally tax deductible.
So why the confusion? Well, its the 'amount' that the loan is taken out for. The main difference is that a home equity loan can also be used like a line of credit. You can borrow as much or as little as you want up to the agreed amount between you and the lender. The second mortgage on the other hand, is for an agreed amount at the outset.
Second Mortgage and Home Equity Facts
A major similarity between a second mortgage and a home equity loan is the necessity for a good credit standing. The reason is that a second mortgage and/or a home equity loan results on a second lien over the property. This means that if you default on your first mortgage the first lender can foreclose and the 'balance' of the sale proceeds is paid to the second lien holder - in other words the 'credit risk' is higher. Depending on the circumstances properties can have more than two mortgages.
To make matters even more confusing second mortgages are also commonly referred to as home equity line of credit, home improvement loan and debt consolidation loans!
One key fact that is often overlooked is that second mortgages/home equity loans qualify for tax relief. This is both good and bad. The tax relief can prompt home owners to borrow more than they would previously have - so it's not necessarily prudent. In addition in a market where house prices are falling this is usually accompanied by a recession and higher risk of unemployment can leave home owners exposed to foreclosure.
You also don't have to borrow the entire amount of equity in the home, if you only need $10,000, and you have $50,000 in equity available then you still have 'reserve of $40,000' that you will not pay interest on.
So what can a home equity loan be used for?
Well, that's up to the borrower. Think of it like this - if you already have two good cars and you'd like another spare one - even if there are only two drivers - this may not be the 'most sensible' use of the money. However if you're looking at consolidating some expensive credit and then paying off the balance of the home equity quickly that is a better use of your resources!
A second mortgage can release cash to reduce or eliminate high payments on the non-mortgage debt and with the increase in tax savings can reduce your monthly payment of debt. However these savings can be offset by a higher mortgage insurance premium (reflecting the perceived increased risk to the lender) and a smaller reduction in debt over the duration of the loan. The secret to successfully taking out a second mortgage is to 'over pay' if you can!
There are plenty of repayment options available to the borrower including interest only payments and annual payments. One note of caution, though, if the borrower is looking at relocation in the near future then pre payment charges will bury any savings - so think of this as much longer term to get the most benefit.
The key issue in getting a second mortgage is the amount of equity you have in your home. A second mortgage is a secured loan which means that this should be an easier loan to get, as long as the borrowers credit score is good. A real bonus is that the interest paid on a second mortgage is in most cases tax deductible. A second mortgage can be a good solution for obtaining funds for school tuition, home repairs and renovations, however it's important to remember that a second mortgage is based on your home's equity and you are putting your home up as collateral. So if something goes wrong - you lose your home and you only have to read in the Press that it does happen!
So a second mortgage vs home equity loan really depends on how much you want to borrow, what for and whether you want it all at once or as in a line of credit! The decision is Yours!
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