Whether you’re buying a home and shopping for a mortgage, or you own a home and want to borrow money against it, you might come across the idea of a second mortgage. A second mortgage is like an ordinary mortgage—a long-term loan made against the value of your house that you pay back in monthly installments. The difference is that it comes after you’ve already had your first loan—also known as your first mortgage or primary mortgage—so you’re piling up additional debt. And of course it depends on the amounts, but in general, additional debt = bad!
Think about an analogy to credit cards; maybe you have one card, say a MasterCard or Visa, that you use all the time, and then maybe another that you use for special purchases. The danger is when your total debt goes over the limit of what you can handle. For some people, the easiest way to prevent that is never to get started in the first place.
Let’s take a look at the two situations where second mortgages come into play.
1. You're Buying a House
The first is when you’re buying a house, and your primary mortgage lender won’t lend you as much money as you want. Maybe you’ve found a $300,000 house you like, and your primary mortgage lender will only lend you 80% of the home’s value—or $240,000. That would leave you needing to put in $60,000 as your contribution, also known as the down payment. You might want to take out a second mortgage to help you with a good chunk of the $60,000. Well, during the boom, people did this all the time—and then ended up putting maybe just a 2% down payment on their houses and borrowing the other 98%. When the downturn hit, many of those people had reduced income and couldn’t make their house payments.
So let’s establish this LearnVest recommendation: It’s okay to take out a second mortgage to buy a house, as long as you can make the monthly payments, AND you put 10% down. I know 10% down can be a lot, but if you don’t have the financial resources to have saved that much, I don’t want you to have two mortgages.
Part of the reason for that is that if you have to sell, it’s easier to deal with one bank than two. Lots of people who are trying to keep their homes by modifying, or changing, the terms of their mortgages are discovering that trying to talk to two banks at once is just a nightmare.
2. You Need Some Extra Cash
The second case where you’d want a second mortgage is where you own a house that has risen in value (kinda unusual in this market) and you want to take out some of that house’s value in order to have some money. This is called a cash-out second mortgage. Why would you want one? Maybe you want to pay for graduate school, or you want to buy your house a new kitchen.
During the boom, homeowners did that and more. Many took out second mortgages to finance purchases that don’t even last ten years, like vacations and big TVs. Renovations and education were a better use of the money – however, a homeowner facing selling into this tough market may find that her new kitchen isn’t enough to sell her house. And even someone with a fancy new law or business degree may find that getting a job is still tough tough tough.
So even though they declared the recession over yesterday, for now, in this sluggish economy, let me recommend no cash-out second mortgages, just as I would recommend that you not get a second MasterCard. If the economy starts booming again, I might change my mind, but for now, better safe than sorry.
Tell us in the comments: Do you know anyone who has taken out a second mortgage? Have you?