As a homeowner, you enter the process of building equity once you start making the first monthly payment on your mortgage – unless you have obtained an interest-only mortgage (negative amortization loan). The opportunity to use equity is just one of the advantages of homeownership.
A “cash-out refinance” can benefit homeowners who need extra cash to make home improvements, to support child’s education, or to help pay off personal debts. Due to the fact you are essentially taking out a new loan using your home as collateral, this will become a second mortgage, or “junior lien” on the property.
Home equity loans and home equity lines of credit (HELOC) are two main forms of second mortgages. One form of a second mortgage is an “open end” loan, meaning that you can withdraw funds continuously on the same account, until you have reached the maximum credit limit. The other form is a “closed end” loan, meaning that you will receive the entire loan amount upfront, with no future withdrawals.
The term “second” means that the loan is subject to another lien against the property. If you can no longer afford your mortgage and the bank forecloses on the property to pay off the debts, the second mortgage will not be paid off until the entire first lien has been satisfied.
Since the second mortgage holder is taking a risk by funding the loan, junior liens will always come with a higher interest rate than a first mortgage, and are typically for a short term, 15-years or less. In addition, some second mortgages (or HELOCs) may require a large one-time payment once the loan matures, commonly known as a balloon payment.
Using the money wisely
– Home Improvement: Using funds from a second mortgage to pay for home renovations is one of the most popular uses for a home equity loan. Besides making the home more appealing or comfortable to reside in, home improvements can also increase your home’s value. Using this funding to handle damages or repairs that are not covered in your standard homeowners insurance policy is a responsible investment. Past reports have shown that nearly 1/4 of second mortgages are aimed at home improvements.
– Managing Debt Load: Home equity can also be advantageous when used to consolidate other debts you’ve acquired. Homeowners with high medical bills, credit cards or student loans can essentially wipe out the debt and avoid potential negative credit reporting. According to reports, nearly 40 percent of all home equity loans are used to pay off other debts.
– Investing: Equity can also be used to make another investment. Although every investment involves some type of risk, a second mortgage is one way of securing a large sum of money quickly. This can be very valuable for small business owners who need quick capital to jumpstart their business, or for investors who eye a huge investment opportunity such as highly rated stocks or bonds. Investing in your child’s education is also very popular, with tuition rates sky-high, students can use all the help they can get to make it through college.
Tip: If you’re considering applying for a second mortgage or HELOC to take advantage of the equity you’ve gained, make sure to shop around various institutions to compare your options. Just like a traditional first mortgage, second mortgages will also consist of various costs and fees to obtain the loan. Make sure to discuss the terms and conditions of the loan with a trusted broker, HUD housing counselor, or financial adviser.
Warning: By taking out another mortgage, you are adding more expenses to your overall debt burden. Anytime you take on a new loan or obtain a new credit card, you may make yourself vulnerable to creditors if you experience a financial hardship and are unable to pay your monthly obligations. Also, it’s crucial to keep in mind that if you are unable to repay the second mortgage or HELOC, you may put yourself at risk of foreclosure because you are using your home as collateral for the loan.