A second home loan allows the homeowner to access the equity in their home. It is the appraised value of the property minus the amount of the first mortgage. Traditionally, second mortgage loans were used to finance improvements.
Homeowners can remodel the kitchen, add a deck, or finish the foundation to provide a family room or home theater. The capital was used to send students to college or to provide start-up capital for a small business. The second loan for most homeowners was a one-time loan for a specific purpose.
Twenty years ago, only the most creditworthy could qualify for a second mortgage, which, when added to a first, would add up to more than 80% of a home’s value. When mortgage interest rates fell in the early 2000s, second mortgages became more common. One contributing factor was the housing bubble that caused home prices to rise by double digits a year in many parts of the country.
Large financial institutions began to ease underwriting restrictions on second mortgages in the 1990s, and by 2001 a homeowner could leverage 100% of the equity in their home with a second mortgage loan. Low interest rates were attractive to homeowners. It has been common for those living beyond their means to consolidate their debt with a second mortgage on their home by refinancing the second mortgage year after year.
In the past, a second mortgage could be expected to carry a higher interest rate than a first mortgage on a property. Variable rate second mortgage liens were offered with initial interest rates as low as 3%. Some homeowners began using their home equity as a mini-bank. They would take out a 10-year second mortgage to pay off the credit card debt, and their monthly payments on the new loan would be substantially less than the payments made on high-interest credit cards.
However, it is important to realize that when you take out a second mortgage on your personal residence, you are in a position of greater risk. Almost all second mortgage loans have a cross default policy. That means if you don’t pay the second loan, the first mortgage will default and you may lose your home to foreclosure. In today’s economy, the rapid decline in home values has meant that thousands of homeowners now have first and second mortgages that are much higher than the market value of their home.
Equity in your home is like having emergency cash in a bank account. Homeowners who treat the cash generated by such a loan as an excuse to go shopping may have a hard time keeping their home. Used wisely, a second home loan is an option available to pay for medical expenses, college tuition, or to improve your property. If used recklessly, homeowners can face the total loss of their home. As such, you should weigh the additional cash you generate against the additional risk you’ll take on before deciding on a second mortgage on your home.