Second Mortgages

If you’ve ever heard someone say they are taking out a “second mortgage,” they are talking about a home equity loan. This is a type of mortgage where homeowners can borrow money by “leveraging” the funds in their home, or the money they’ve already paid into the principle of their mortgage.

Home equity loans became popular in the mid 1980s as a way for homebuyers to gain back what was lost in the Tax Reform Act of 1986 which would no longer allow deductions of mortgage interest. With a home equity loan, homebuyers could borrow back $100,000 of the value of their homes and receive tax deductions on the interest. However, taxes have changed and now homeowners can only receive tax deductions on a home equity loan if the loan money is used for significant improvements and home renovations.

There are two types of home equity loans that a lender can give a homebuyer, and they both are created to be paid off in 5-15 years. Those include:

• Fixed-Rate Loans: A homebuyer receives one lump sum upfront and then pays it back over time with a set interest rate. Requirements of the loan are locked in when the loan is taken out, such as the monthly payments and interest.
• Home-Equity Line of Credit: This type of loan works similar to a credit card, which is why it’s called a “variable-rate loan.” When approved, a homebuyer will receive a specific spending limit that they can draw from when the money is needed. They may even receive a credit card to draw those funds from the loan each month. Because it’s a variable-rate loan, monthly payments and interest are determined by how much money is borrowed at the current interest rate of the loan. You want to be more careful with this type of loan because you need to have a steady income in order to keep up with payments, as the leverage is the equity you have already paid off on your original mortgage.

There are pros and cons to taking out any type of loan or line of credit. However, if you read the fine print, you can stay out of a lot of trouble and avoid surprises. 

Simply remember that you are borrowing the equity in your home. Equity means you own something that has debt attached to it, but part of the item is paid off. Example: If your home is worth $200,000 and you still owe $80,000, then the equity is $120,000 because that much has already been paid off. When getting a home equity loan, keep in mind that your home is used as collateral. If you default on the loan, the bank could foreclose on and take possession of your home. Generally, interest rates are higher for home equity loans than they are for the fixed-rate version and other consolidation loans. You will also have to pay closing costs and fees, but this is common with many types of loans.