Second Mortgages: Loan products beyond the first mortgage.
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Mortgage loans are called "second" mortgages whenever there is an existing mortgage on the property that will not be retired by the new loan. This loan is positioned behind the first mortgage, which means that if the homeowners default and the property is sold, the holder of the first mortgage gets paid first, and then the holder of the second mortgage gets paid if there is money left over. This makes second mortgages riskier than first mortgages, so their rates are higher. However, because second mortgages are secured by property, they are still among the cheapest financing options available. In addition, second mortgages are much less expensive to originate than first mortgages, typically costing $500 or less.
Borrowers put second mortgages to many uses, from financing cars and vacations to consolidating debt, paying for home improvements, or starting businesses. Homeowners should consider the implications of trading home equity for cash before taking a second mortgage; the lack of an equity cushion could make it difficult to sell the home should it become necessary. In addition, studies show that many homeowners who use their home equity to consolidate debt promptly run up their credit cards again, leaving them with no equity and more debt than before. However, homeowners who use their home equity wisely and keep a lid on expensive unsecured debt can really enhance their financial health.
Second mortgages take the forms of fixed rate home equity loans (HELOANS) or home equity lines of credit (HELOCs). Each option is best suited for different needs, and determining which loan is best is largely driven by the use to which the money will be put, the amount of available equity in the property, and the homeowners' tolerance for risk.
Cashing out home equity with a HELOAN involves receiving cash for the entire loan amount and repaying it by making fixed equal monthly payments until the debt is retired. This makes the loan ideal for situations in which the entire amount will be needed at once, like debt consolidation or financing the down payment on a rental property.
Home equity lines of credit work differently. The borrower is granted a line of credit and can draw funds and repay them, again and again. This is called revolving credit and is similar to most credit card accounts. These loans are ideal for recurrent expenses, like college tuition, or uncertain expenses, like a long-term remodeling project or emergency funds for a new business. HELOCs feature variable rates (usually based on the prime rate) and a payment determined by the amount of credit used and the interest rate.