This year we took the plunge and built our dream home. Along the way, we learned a lot in the building process, especially when it comes to the mortgage loan process. Our first home was bought while I was in Iraq, so I cashed in on my veteran status used the VA home loan. With our dream home, we were short the 20% down payment that we needed to avoid PMI (Private Mortgage Insurance). While we could have used the VA loan again (for refinancing not for first time home purchases), it was actually cheaper to do the traditional loan process and take out a second mortgage.
A second mortgage is basically a loan using your home equity as collateral. If you own your home, whether you have a mortgage attached to the property or not, you may be able to secure a second loan by liberating your equity that has built-up over the years.
Generally speaking, real estate increases in value, so while a typical mortgage can stretch out for up to 30 years, the principal owed on the house steadily falls while the value of the house appreciates. To find out how much you can possibly qualify to borrow on your home you need to find out how much equity is in your home. This is calculated by estimating the market value of the property and subtracting the payments made towards your first loan so far.
For example, if your home is currently worth $250,000 but you have a first mortgage of $160,000 outstanding on the property, you have managed to amass $90,000 in equity. Lenders may be willing to allow you to borrow anywhere from 60% to 80% of your equity, which works out to roughly $54,000 to $72,000.
What are Second Mortgages Used For?
As you can see a second mortgage can really represent a sizable chunk of cash, but what are they used for? Well, you can use a second mortgage for anything from funding a child’s education to making repairs on your home. I’ve had a client take out a second mortgage to put in a new pool.
If you are going to take on additional debt,it should be for something worthwhile. A vacation, however deserved might be better to save for slowly, that to take on the cost of a home equity loan.
Another option can be to avoid Private Mortgage Insurance. As I mentioned above, we chose to do a second mortgage to avoid PMI. We had the option to use the VA Loan again, but we would have had to pay a 0.5% funding fee, so the second mortgage made more sense for us. Although we financed the second mortgage over a 30 year period, we had set a goal to have it paid off in 2 years (after just recently refinancing we’ll now have our second mortgage paid off in under a year).
Pros of a Second Mortgage
The good news about a second mortgage is that mortgage interest of up to $100,000 of the principal for married couples and $50,000 for singles is deductible on your tax return as well. Although this is meant to be a combined mortgage interest on both your mortgage loans it is still a great deduction, especially if your first mortgage is closer to the end of its life and so has a relatively small portion of interest payments left.
Another (possible) pro of taking out a second mortgage is the ability to liquidate the equity in your home. If you are on the verge of bankruptcy and you need to get access to cash to pay off high interest loans and back taxes, taking a home equity loan might not be a bad trade. The interest payable on a home equity loan is usually lower that other types of debt because it offers the lender the security of your house.
While this might seem like a smart strategy, one thing you never do is borrow against your home to pay off credit cards. I cringe every time I hear of someone pondering that.
Cons of a Second Mortgage
Taking out a second mortgage is not without its drawbacks. For instance, you need to remember that even though the loan does provide you with the cash you want it comes at the cost of putting your house up for grabs in the event you cannot make good on the loan.
A second mortgage is also not without its costs. You have to pay for an appraisal on your house, loan origination and other legal fees associated with an ordinary loan, so although there is a lower rate of interest there are other costs to consider.
If you’re one that has a rough relationship managing debt, I would strongly have you reconsider taking out a second mortgage to pay off debt. You first have to fix the root of the problem which is most likely – you. A second mortgage is not the answer for everyone so think about all the factors before making your final decision.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
