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If you are looking for a way to get some extra cash to pay off credit card debt, send your kids to college, take a big vacation, or renovate your home, you have probably found a second mortgage or home equity loan as an option.
A “second mortgage” is a generic term that is used to describe a loan taken out with real estate serving as the collateral property in which the lender does not have the primary claim to the collateral in the event of a default.
Second Mortgage and Home Equity Loan Differences
In most cases, a home equity loan is just a specific type of second mortgage. There is one case that serves as an exception, which we will cover below. But first, a home equity loan lets a homeowner borrow against the equity in the home. The amount the homeowner can borrow is dependent upon the difference between the current value of the home and the total outstanding mortgage debt.
A mortgage contains a clause that states the lender must be the primary lien holder against the property. So, any other debt that has the same property as collateral must be secondary to the mortgage. After you pay off your mortgage, however, the lender releases the lien against the property and no longer has a claim to the collateral.
You can, however, borrow money with a home equity loan even if you no longer have a mortgage. In this case, you are borrowing against your 100 percent equity stake in the home. The home equity loan will be the first lien against the property since it does not have to be secondary to any other mortgage lien. When you have 100 percent equity in your home, the home equity loan is not a second mortgage.
Second Mortgage and a Home Equity Loan Similarities
If you take out a home equity loan while you already have outstanding mortgage debt, your home equity loan gets classified as a second mortgage. The home equity loan lender has a secondary claim to the collateral property in the event of default.
If a borrower defaults on either the mortgage or home equity loan, the lender will initiate foreclosure proceedings. The primary mortgage lender has the first claim to the proceeds from foreclosure, and the secondary lien holder has a claim to anything that is left over.
The home equity loan or second mortgage has a slightly higher interest rate than the interest rate on a first mortgage. The interest rate is higher because the lender’s claim to the property is considered to be riskier than that of the mortgage lender with a primary claim to the collateral property. Home equity loans usually have a fixed interest rate and a 10 to 15-year term.
Home Equity Loan & Second Mortgage Uses and Risks
Other than the relatively low borrowing cost, one of the biggest benefits of a home equity loan is its flexibility. Borrowers can use the proceeds from the loan for any individual use they need. There are not any restrictions on how the borrower can use the money. Borrowers may use the home equity loan to consolidate or pay off high-interest credit card debt, take a family vacation, buy an investment property, send their children to college, or renovate their home.
Although the interest on home equity loans used to be deductible on the borrower’s federal tax return, the law changed in 2018. The interest borrowers pay on their home equity loan is only deductible on their federal taxes if they use the proceeds to make a significant renovation or improvement on the underlying real estate.
The biggest risk from using a second mortgage or home equity loan is the risk to your home. Borrowers are able to access large amounts of cash at a relatively low interest rate when compared to credit cards or personal loans. This is only possible because the borrower’s home serves as collateral to secure the loan.
If the borrower later faces financial hardship and cannot make the monthly payments on the home equity loan or second mortgage, the lender will foreclose on the underlying collateral property in order to meet the borrower’s debt obligation. Since borrowers can potentially lose their homes due to default, they should seriously consider the risks associated with the loan and all other alternatives before taking out a second mortgage or home equity loan.
Author: Kimberly Goodwin, PhD