A second mortgage can be a useful financial Tool

This phrase might seem a little odd: “A second mortgage?” If you already have one loan, why would anyone want another?

Second mortgages, also known as home equity loans, can help you achieve other financial goals. It may be worthwhile to consider a second mortgage in these times of historically low interest rates and rapidly rising home equity.

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What is a second mortgage and how does it work?

People often refer to “second mortgage” as a home equity loan, or home equity credit line (HELOC).

Matthew Stratman is the lead financial advisor at California’s South Bay Planning Group. He says that a second mortgage is essentially a loan on your home that takes a second place after your primary mortgage.

Home equity loans or HELOCs are second mortgages that homeowners who have enough equity can borrow against. Your equity is calculated by subtracting the remaining loan amount from your total home value.

Experts say that you can only borrow up to 85% of the value of your home. If your home is valued at $400,000, then the maximum loan amount that most borrowers can take out would be $340,000. If you still owe $200,000 on your primary mortgage, this would give you $140,000 equity.

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Types of second mortgages

There are two types of second mortgages available: a home equity loan and a home equity credit line (HELOC). A home equity loan allows for you to borrow one lump sum at a time. A HELOC, on the other hand, functions more like a credit-card. You can spend the amount up or down, and only pay what you use.

This is a detailed explanation of each type of second loan.

Home Equity Loan

The home equity loan is similar to your primary mortgage. You will need to give the lender all your financial information in order to be eligible for one. The lender will evaluate the value of your house and determine how much home equity loan you are eligible for. You can then take out the money in a lump sum, which you would pay back over a period of 20 or 30 years with interest.

Stratman says that one of the greatest benefits of home equity loans is the low interest rates. Mortgage lending rates are generally lower than personal loans and credit cards. Home equity loans are a great option for home renovations that don’t require a large upfront payment but can potentially increase the value of your home.

HELOC

HELOCs are revolving credit that works in the same way as a credit card. A HELOC would be applied for in the same manner as a home equity loan. The lender would set a maximum amount you could spend. The credit limit you have will be limited to 85% of the value of your home or less. When determining your limit, lenders take into account your credit history as well as income factors.

You can spend as much as you like during the “draw period.” After the draw period ends, you will have to pay back any amount that you used.

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Stratman states that a home equity credit line is a good option if you need the ability to access it. However, you may not be able to predict when you will need it.

For example, if there is an emergency roof leak, HELOCs could be a great option. They can also be useful for planning larger home renovations.

The Second Mortgage vs. Refinance

Refinance your home is another popular way to manage major expenses and strengthen your financial base. Refinancing and second mortgages are two different things. Both can help you save interest in different ways.

Refinancing allows you to essentially restructure your primary mortgage, often at a lower interest rate and with better terms. A second mortgage by arbitration is different. This means that you don’t save interest on your principal mortgage. Instead, you can use the money borrowed from the second loan to pay off high-interest debts or purchase something you wouldn’t have bought if you had a high-interest credit score.

A Second Mortgage: The Pros and the Cons

While second mortgages can be used for many purposes, it is important to be aware of certain risks and limitations.

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Pros

1. Lower interest rates than other types of debt like personal loans or credit cards
2. This can allow you to make more money in your home over the long-term.
3. Flexible HELOCs allow you to pay only for the services you use.

Cons

1. This will increase your total debt.
2. You can add another loan payment on top of your monthly bills
3. If you aren’t careful, HELOCs can tempt your to live beyond what you have.
4. The cost of adding a second mortgage payment to your primary mortgage might be higher than a cash-out refi.