Advice on Second Mortgages

Making the most of home ownership – without betting the farm

SAN MATEO, Calif., Sept. 13, 2006 - Against the backdrop of rising interest rates and cooling home sales leading to slower increases - and even decreases - in home values, second mortgages have lost their luster. But are they still a valid financing tool? According to Andrew Housser, co-CEO of Bills.com, the answer is a qualified "yes." "Used sensibly, home equity loans let homeowners draw on their greatest asset to achieve greater financial stability," Housser said. "The key is to evaluate thoroughly the terms and risks of a second mortgage to decide if it is right for you." A first mortgage covers the bulk of a home’s purchase price. Like first mortgages, second mortgages cover part of the debt on a home. They typically have terms of 15-30 years, and they can have fixed or variable interest rates. Homeowners can borrow a set amount at once - a traditional second mortgage - or open a home equity line of credit, which allows owners to borrow from their equity on as as-needed basis. In several situations, a second mortgage can be a good tool, Housser explains. Home equity borrowing can be sound when:

  1. The interest rate is fixed. Despite the Federal Reserve’s recent pause after 17 straight rate increases, the possibility of rate increases still exists. In comparison to fixed-rate mortgages, adjustable rate mortgages (ARMs) start at a lower rate and thus a lower payment for consumers. In an environment of rising interest rates, rates on ARMs can increase surprisingly quickly, raising payments beyond buyers’ abilities to pay.
  2. You understand the terms and have a plan in place. Some second mortgages require a "balloon" payoff after 10-15 years. This means you pay only part of the debt with your monthly payments, with the rest due all at once. This situation can make sense if, for instance, one spouse is in school and will certainly have a better job in a few years, and you can pay off the loan before the balloon clause takes effect. You’d be smart to maintain good credit to allow for the possibility of refinancing to cover the balloon payment if necessary. And if interest rates increase, you’ll need higher income to refinance into a higher-value first mortgage.
  3. Home equity is used to improve the property, and payments are well within your budget. These loans can be great for home improvements (like a new roof, new windows or remodeling). However, some homeowners get into financial trouble when they borrow for other reasons, such as to cover day-to-day living costs or "splurge" purchases.
  4. You need a large sum of money to pay for education or a lasting purchase such as a second home. Obviously, you should borrow against your home only if you are confident you can manage the payments and expenses. If so, a second mortgage offers a way to leverage your equity to invest in other areas that can have a lasting impact on your earning potential and future wealth.
  5. To pay off debt - such as high-interest revolving credit card debt - in certain circumstances. Shifting unsecured debt to debt secured by your home should be approached with caution. Risking your home is a viable option only if you meet several conditions: (a) You have significant equity in your home and will not borrow more than the value of the home. (b) You have stopped adding to the debt and have a plan in place to avoid incurring more debt. (c) Your payments would be significantly lower on a mortgage than on the accumulated debt sources you will be paying off. (d) Your peace of mind would be improved by having just one monthly payment. (e) You are confident your lender is reliable and trustworthy.
  6. You’re using "piggyback" financing to buy a home with an affordable total payment (not exceeding 35 percent of your monthly net income). Traditionally, homebuyers put down 20 percent of a home’s value in cash. If the down payment is less than 20 percent, lenders require the buyer to purchase private mortgage insurance (PMI) in case of default on the loan. To avoid PMI, some homebuyers use "piggyback" second mortgages. In this scenario, a first mortgage covers 80 percent of the home’s value. Then, a second mortgage makes up the difference between the home’s value and the buyer’s down payment. The second mortgage has drawbacks - such as a higher interest rate - but that expense can be offset by savings on PMI and the fact that the interest on your second mortgage is tax deductible, while PMI is not.

"If one of these situations fits you, you may consider using your equity to your advantage," said Housser, who added that payments on a second mortgage can have tax benefits, and borrowing this way can help make the most of home ownership. "Always remember, however, that your home is your most precious asset - and one that you must keep safe, whether you have one mortgage, two mortgages or, ideally, none at all." Based in San Mateo, Calif., Bills.com is a free one-stop online portal where consumers can educate themselves about complex personal finance issues and save money by choosing the best-value products and services. Since 2002, Bills.com’s partner company, Freedom Financial Network, has provided consumer debt resolution services, serving more than 10,000 customers nationwide and managing more than $250 million in consumer debt. The company’s co-founders and CEOs, Andrew Housser and Brad Stroh, were recently named Northern California finalists in Ernst & Young’s 2006 Entrepreneur of the Year Awards.