Second mortgages: popular for good reason
Second mortgages can be great sources of cheap money.
Most of the time, second mortgages go very well and provide money at a reasonable cost. Knowing what to avoid can help you have a good experience with your second mortgage.Verify your new rate (Jul 18th, 2019)
What are second mortgages?
A mortgage is a loan secured by your home. A second mortgage is one you take out when you already have a first (primary) mortgage.
Second mortgages are riskier to lenders than first mortgages. That’s because in a foreclosure sale, the first mortgage gets paid off first. The second mortgage may not be completely repaid from the proceeds of the sale.
Second mortgages are cheaper than most other loans because they are secured by real estate. But they come with higher rates than first mortgages.
The most common types of second mortgage are home equity loans (HELs) and home equity lines of credit (HELOCs). It is possible to have one of those without having a first mortgage (you never had one or you’ve paid it off) but they’re relatively rare.
1. You don’t verify that you can “subordinate” the HELOC
When you have more than one loan against your home (a first mortgage plus one or more HELs or HELOCs), they form a hierarchy: first lien, second lien and so on. The oldest loan takes precedence and gets repaid first in the event of a foreclosure.
Only once the first lender recovers all its money, including expenses, does the next lender in line get paid. And only after that does the holder of your third lien get its turn. That’s why interest rates tend to get higher with each lien you add.
New becomes a problem
This hierarchy based on the age of the loans usually works fine. But supposing you want to refinance your main (first) mortgage.
That involves paying off your existing loan and replacing it. So your second mortgage suddenly becomes your first in the hierarchy because it’s now the oldest. And your main mortgage — your biggest and newest loan — would go to the bottom of the queue. That would be unacceptable to your new mortgage lender.
If your second mortgage holder refuses to subordinate its loan, putting it behind the new first mortgage, you won’t get your new first mortgage. This does happen, and almost no one checks out a lender’s subordination policy before accepting a second mortgage.
Check before you sign
Luckily, this is only a problem relatively rarely. Most lenders of HELs and HELOCs understand the issue and voluntarily agree to give up their first-lien status to allow a refinance.
But not all do. So you need to crawl all over your loan agreement on any second mortgage you take. You must make sure your new lender has a sensible policy over “subordination,” which is allowing the main mortgage to remain the first lien. If the agreement doesn’t mention it, get a signed letter from the new lender agreeing to retain second-lien status in the event of a refinancing.
If you already have a second mortgage lender refusing to subordinate, your best bet is paying off that lender and refinancing your second mortgage when you refinance your first mortgage. Or wrapping the old second mortgage into your new first mortgage.
2. You don’t realize your payment will skyrocket after 10 years
Home equity lines of credit can occasionally catch out unwary borrowers. It’s built into their structure.
You get a line of credit that lets you borrow, repay and borrow again up to your credit limit for a fixed period. That’s usually 10 years for a 30-year loan. And during that time, you need only pay interest on your balance. But the payment can skyrocket when you start paying principal and interest.
This is called your draw period. And, once it’s over, you enter a repayment phase, which is often between five and 20 more years.
Some borrowers get into trouble transitioning between the two periods. Suddenly, you can’t borrow any more. And you have to zero your account, paying down both the interest and “principal” (your closing balance) according to a set timetable.
Problems and solutions
Of course, you know this is coming. But you can easily forget about it over a decade-long draw period. And some borrowers — especially freelancers and those in the gig economy who need a line of credit to even out the peaks and troughs in their earnings — find themselves in trouble.
There are often simple solutions. For example, you could refinance your main mortgage to clear the balance in one fell swoop. Or you could take out a straight home equity loan to achieve the same. Or you could refinance your HELOC. But all those rely on your still having a decent credit score and plenty of equity in your home. And life’s not always that kind.
3. You don’t negotiate with the lender early on if you get into trouble
Second mortgages can pose a particular threat to those in financial trouble.
Companies that lend second mortgages may hold only junior liens. But they can and do foreclose on borrowers who fall seriously behind on payments. In other words, you need to keep up with HELs and HELOCs as much as you do your first mortgage.
Foreclosure isn’t always the end of it
Even after a foreclosure, you may remain vulnerable. If the sale of your home doesn’t raise enough to cover all their losses on your secured borrowing, lenders can often still come after you for the shortfall. And that can happen even in blood-from-a-stone scenarios.
Of course, bankruptcy may provide relief. But your credit score can then take a decade to begin to recover.
Your best bet for avoiding foreclosure is to negotiate with your lenders early on. But maybe you’ll be tempted to put off getting in touch until you have some good news.
Don’t be. Counterintuitively, someone in a bad situation can have more leverage than someone in a slightly better one. Suppose your home is “underwater,” meaning the secured debt you owe on it exceeds its market value. Or your income and assets are currently very low.
Lenders may hate those things but they may also recognize the futility of foreclosing or being inflexible over payments. They may decide that their best chance of eventually getting their money back is to give you some space to get back on your feet. So work with them early on.
But don’t automatically disregard second mortgages
Of course, very few second mortgages go so horribly wrong. Odds are, you’ll borrow and pay back with little or no hassle. And mortgage financing is some of the cheapest available.
But all first and second mortgages require you to put your home on the line. So don’t take one on without first weighing its benefits and risks.Verify your new rate (Jul 18th, 2019)