In the 2000s, a trend among U.S homeowners was to exploit their ability to withdraw equity from their house to fund anything they needed. As a result, you got the housing market crash of 2007.
This left many people fearful of anything to do with second mortgages and equity, convinced that taking out even a little money could pull out the rug from underneath them.
But if you borrow responsibly in times where you need the cash, it’s a valuable option. But when are these times?
Well, we’re glad you asked. Read on to discover our guide on figuring out when taking out a second mortgage makes sense! However, we first need to take a look at how these mortgages work.
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What is a Second Mortgage?
A second mortgage occurs when you decide to take a loan out on your house’s value while you are still paying off the mortgage. Since the first mortgage still exists (and thus you don’t officially own the house yet), the amount you put up for collateral is dependent on your home equity value.
Fortunately, determining the equity value of your home isn’t too complicated. To do this, you need to find the market value of your house (or the current price of your house if you were to buy it now).
You then take that value and subtract the amount of principal you still have left to pay on your mortgage to get your equity value. However, likely you won’t get to borrow from the full “pot”, but rather a percentage of it based on your credit score. If you want to learn more about how to manage mortgage credit, there are plenty of free sources online to help.
Home Equity Loans
From there, you can use your home equity value in two ways. One is through a home equity loan, where you can borrow money and use your “share” of the house as collateral.
Unlike other loans, home equity loans have no limitations on what you can use the money for. This means you can use it to plug up any surprise costs that come your way without worry.
On the plus side, home equity loans give you a lump sum upfront and exact interest rates so you know what you’re getting into. On the other hand, extra “closing fees” can pop up and exacerbate your payment size. Also, should you fail to keep your end of the bargain up, the bank gets to seize your house like they would with the initial mortgage payments.
Credit Lines
Another option at your disposal is getting a home equity line of credit, which transforms your equity value into a sort of credit card. It starts with a 5-year draw period, where you can take out as much money as your credit limit allows. The only thing you’ll need to pay for during this period is interest rates on the loans you take out.
After that comes a 10-year (sometimes longer) repayment period, where you have to pay back everything you borrowed plus even more interest. This gives you more options than a home equity loan since you can take out cash at your discretion over time.
However, due to this extended time, equity credit lines are more subject to market changes than their loan brethren. As a result, your payment values will vary based on the strength of the market. This makes it difficult to plan for what you’ll need to pay.
Qualifications for Taking Out a Second Mortgage
That said, there are certain requirements you’ll need to meet before the bank will give you access to these tools. For starters, you’ll need to bring them some form of documentation that shows you are employed and/or receiving a steady income from some valid source. You’ll also need to show that less than 43% of your income goes towards paying off pre-existing debts.
Another prerequisite is that your credit score needs to at least be 620 or higher. Finally, your equity value needs to make up at least 20% of the market value of your home.
It’s also important to take a long look at your financial situation before you get involved in the world of equity loans. Interest rates can skyrocket if you’re not careful, and you risk losing your house if you come up short.
When Does Taking Out a Second Mortgage Make Sense?
A good rule of thumb is that you should take out a second mortgage on something that will “pay itself off” down the line. For example, taking out a second mortgage to help pay for college makes sense since that college education will give you access to higher-paying jobs than you would have without it.
Another situation second mortgages are useful for comes if you want to avoid taking out credit card debt. Home equity loans tend to carry lower interest rates than credit card companies put on their clients, making them safer financial options.
Second mortgages also help eliminate PMI (or private mortgage insurance). These payments pop up if you paid less than 20% of a home’s value when you made the down payment. As long as you check that it’s not cheaper to stick with PMI, the money you borrow from second mortgages can wipe these pesky costs off the board.
Finally, using second mortgages to make home improvements work out since these improvements will likely spike the market value of your home up, increasing the pool of money you have to get equity loans from. Plus, sometimes you can get tax cuts on your interest payments if they are used for this purpose, though the process is wrapped in tons of conditions.
A Safe Financial Future
And there it is! Now that you have this guide to when you should consider taking out a second mortgage, you can feel free to do so without worrying about subjecting yourself to financial ruin! And for more information on the housing market and managing your mortgage, be sure to check out the other articles on our blog!