Second Mortgages

Reasons Why People Take Second Mortgages

During the initial financing of a home, a borrower will borrow a certain amount to cover the its purchase, less their down payment. Over time, the intention is to pay down the mortgage and earn equity.

Equity is earned in two ways, by paying down what is owed on the property and by seeing the property increase in value. Eventually, if the mortgage is held long enough, it will become paid and the owner will own the home free and clear.

In this case, one can be free of having to make mortgage payments, and we could then say that the utility of the equity that is being built up over time can eventually serve to free one from these payments, and also be completely debt free, and this is certainly a nice outcome.

The great majority of homeowners are not in this situation though, and don’t enjoy this benefit, in fact they typically not only are making a mortgage payment but other payments on debt as well. This may involve a variety of other payments, car loans for instance, loans for other purchases, loans to consolidate other debt, credit card payments, and so on.

The equity that one has built up over the years can be a very valuable tool in managing this other debt, not only as a means to pay less interest on the debt they have, but also to manage cash flow problems. People often get themselves in trouble by taking on debt payments that are at least somewhat uncomfortable, if not unmanageable. Reorganizing this debt to extend the amortization of some or all of these debt is often even more important than slashing the interest they are paying every month, although both can be a very important and often necessary goal.

There are two main options in looking to utilize one’s home equity to help out with debt management, which are refinancing the original mortgage and taking on a second mortgage, whether this means another loan or a line of credit secured by home equity.

Remortgaging Is Often Seen as Some Sort of Failure

Many people have the attitude that remortgaging, adding debt on to a mortgage, extending the amortization, or both, is something that we should work hard to avoid, and when we are forced into such a situation, it is a result of a failure in our ability to manage our affairs.

Often times, people do fail to manage their finances properly, borrowing too much, and we should certainly be paying attention to looking to avoid this. The appeal of borrowing can be a pretty intense one, and a lot of people borrow more than they should overall.

When we do find ourselves in these situations, or even when more sensible borrowing has us racking up a meaningful amount of debt, it is certainly a mistake to hold an attitude that paying off our mortgage is a primary and independent goal and we should be very reluctant to add to this debt and extend the amount of time we expect to become mortgage free.

It is certainly good to have a goal to be debt free, but we should never view our mortgage debt as somehow independent and especially be more eager to pay it down over our other, higher to much higher interest debt.

There are plenty of people who will, for instance, make extra mortgage payments instead of making extra payments on higher interest debt, and may also pat themselves on the back when they finally get their house paid off, and miss the fact that this strategy may have cost them a lot more money in interest payments.

As a rule of thumb, if we have to choose between paying more or less interest, we should always seek to pay less. This means that we should be looking to pay as little as we can on the lower interest debt and as much as we can on the higher interest debt.

There are two main categories of debt, that which is secured by our home equity, which has lower rates, and all other debt, which comes at higher rates.

It often makes perfect sense to not only add to our mortgage debt, but to also extend the period of time it will take us to pay off our home, which is the opposite of what a lot of people think we should be doing. When we take this approach though, this will result in our becoming debt free faster, or at least reducing the cost of carrying our debt as we pay it off, which has to be the goal.

Overly focusing on mortgage debt is also promoted by a lot of advisors, those who are advising people how to manage their debt and are in the business of selling mortgages. They certainly may have a better understanding of the need to manage debts with home equity than their clients have, and clients will often have a fair bit of reluctance, but these advisors may not fully get how to best approach this.

This can result in clients taking a less than ideal approach to managing their debts, not adding enough to their mortgages perhaps, and especially not looking to reduce the payments on their mortgages enough. This results in more money going toward the mortgage than needed, less money going towards the higher interest debt, too much interest being paid, and often, too high payments being made overall.

Balancing Longer Term and Shorter Term Debt

While the idea of paying lower rates on debt is a pretty easy one to manage, as you just look to move debt from a higher rate to a lower one, the longer amortization of mortgages versus other forms of loans does allow us to lower the payments on a given amount of debt pretty substantially and requires a good understanding and a fair bit of discipline to execute the plan well.

Let’s take the example where someone is paying $400 a month for another 3 years on a car loan. The rate on the car loan is twice that of a mortgage rate. Perhaps the borrower has other debt, credit card debt for instance, where they are paying several times more than the car loan rate on. Perhaps money is a little tight and they just want to free up a couple hundred dollars a month to give themselves some breathing room.

Instead of paying off the car in 3 years, we can perhaps look to set the amortization on this debt to 30 years, or perhaps move it to a non amortizing product such as a line of credit. Let’s look at the 30 year idea though, as this is something many borrowers get confused with.

So they often are quite reluctant to do this, and they may be thinking, what’s going to happen in 3 years when I need a new car, and now I have to make payments on the current car for 30 years plus the new car payment then. Advisors will sometimes even try to trick clients into thinking that the amount that they lowered their payments by now is some sort of savings, and even project this many years into the future, conveniently ignoring that people will still need to borrow for another car later, and probably do so for many years, if not indefinitely.

Amortizing this car payment often is a great idea though, and sometimes even a brilliant idea depending on how bad off the borrower’s cash flow situation is, and can even save both the car and the mortgage in some cases. This still needs to be used responsibly though and not as a tool to get ourselves in even more trouble, which can happen if we’re not careful.

Extending the amortization of debt does involve us taking longer to pay it back of course, but it also allows us to better manage things when it allows us to spend our money on paying off other debt that is at a higher rate, and especially, to allow us to comfortably meet all of our obligations and not fall further and further behind, as happens to a lot of people.

This is where adding to one’s mortgage, or taking a second mortgage, comes in, and this can be a valuable tool to both manage existing debt as well as future debt.

Types of Second Mortgages

In most cases, people should be looking at adding a line of credit as a second mortgage. Secured lines of credit are indeed mortgages, technically called collateral mortgages. Sometimes borrowers get confused about this when they read the legal agreement and see their line of credit as being referred to as a collateral mortgage, but this is due to their not fully understanding what a mortgage is, and it is not always a fixed amount of money advanced by a loan, as a standard mortgage is.

Deciding whether to go with a loan or a line of credit when it comes to getting a second mortgage is similar to making such a decision when it comes to unsecured borrowing, although secured products do play a more primary role in one’s finances and therefore one may expect to use it more, and benefit more from the additional flexibility of a line of credit.

Setting up mortgages does cost money, and when you have to pay a lawyer to do things like title searches and drawing up documents, this is not something you want to need to do very often. When you get your second mortgage by way of a loan, and need to borrow more later, this means that you’ll have to pay these costs again.

In needing to do so, the threshold of borrowing needs to be high enough, and you can’t really make sense of borrowing another $1000 for instance and have it cost you $1000 to do it. If you only have that much usable equity, the costs involved will take up the entire amount you could borrow.

With a line of credit or a collateral mortgage, you can borrow any amount you want provided that you have the available room, so if you pay down $5000 for instance and need to re-borrow some or all of this later, you can do so without re-doing your mortgage or adding another one.

Many years ago, people used to add a lot of second mortgage loans, but nowadays, with the much greater prominence and availability of secured lines of credit, this is the most popular option by far for those who have at least good credit.

Subprime lenders still focus on loans though, although these loans do come at a much higher rate than prime lenders offer and should only be used when really needed. There is a time and a place for them though, if that’s all you qualify for and taking out these loans involves significant interest savings and/or a much better cash flow picture.

Paying more interest is a relative thing, and ideally we’d not let our credit scores get so out of hand that this is all we can qualify for, but if we do, then these kind of loans can actually save our finances and our home as well.

Due to the ease and often reduced cost, it often makes sense to add a second mortgage over re-doing the first mortgage, but in all cases, we need to carefully compare the options and go with what costs the least and provides the most benefits.