What is a second mortgage?

ALASDAIR DUNCAN
You may have heard the term ‘second mortgage’, but what exactly is it, how does it differ from a traditional mortgage, and what are some things to be wary of before applying for one?

If you’re paying off a home loan and need to access some additional funds, whether it’s to purchase an investment property, assist a family member in buying a home, or even to consolidate your debts, a second mortgage might be one option to consider. Before taking one out, though, it is important to understand the ways in which a second mortgage differs from a first, and any potential pitfalls to be wary of. In this article, we’ll answer the questions:

What is a second mortgage?

A second mortgage, simply put, is an additional mortgage you can take out on a property that already has one. You might take one out if you wish to use your equity in your current home to access additional funds.

While the terms ‘mortgage’ and ‘home loan’ are often used interchangeably, they have distinct and separate meanings, and understanding the difference is important when it comes to understanding what a second mortgage is and how it works.

Typically, when you buy a home, you will take out a home loan to fund the purchase. The home itself will be used as collateral on the loan, and if you are unable to make your repayments, the lender will have the right to sell it in order to recoup the money owing to them. This arrangement is called a mortgage.

What makes a second mortgage different from a primary one?

Mortgages are typically paid off in monthly instalments, and while this is happening, the home is also likely to appreciate in value. The difference between the market value of the home and the balance of the current home loan is called home equity. You can take out a loan on your equity, using the home itself as collateral, and this arrangement is called a second mortgage.

In this way, it is somewhat similar to a line of credit home loan, which can allow you to borrow money up to a pre-approved level, using the equity in your home. Unlike a line of credit home loan, however, a second mortgage would typically be taken out with a different lender than the first.

How does a second mortgage work?

A second mortgage is paid off in the same way as a primary one, with the borrower making repayments at agreed intervals, typically in fortnightly or monthly instalments. However,  a second mortgage is unique in that it is subordinate to a primary one.

If you take out a second mortgage on your property, it will be ranked behind your first in order of priority. This means that if you are unable to make your repayments and your property is sold off to pay your debt, then the first mortgage will be paid off before the second.

Consider this hypothetical example: You have a mortgage on a loan of $200,000 with Lender A, with your home as security. You then choose to take out a second mortgage of $200,000 from Lender B, with your home as security once again.

If you are unable to make your repayments on your loan, Lender A would have the right to sell your home. Say they received $250,000 from the sale. Lender A would be entitled to repayment in full, while Lender B could only receive whatever amount is left over.

Lender B could potentially end up with very little, and it is for this reason that lenders may be more cautious when offering second mortgages.

Why might you take out a second mortgage?

If you plan to use the equity in your home to access additional funds, but your current lender has turned your application down, then you might choose to apply for a second mortgage through a different lender. There are a number of possible reasons why you might want to access the equity in your home, including:

  • undertaking a home renovation project
  • acting as a guarantor for someone else’s loan
  • freeing up funds to purchase an investment property
  • paying off student loans

What should you be cautious about with a second mortgage?

If you are considering a second mortgage, it is worth being wary of higher fees and charges, fees from your primary lender, your own budgetary considerations, tougher lending criteria, and the risks of using a second mortgage to invest in property.

Higher fees and charges

Lenders tend to view second mortgages as riskier than first ones, as they are second in order of priority and in the event of a default, will only receive funds from the sale of a house after the primary lender has taken what they are owed. For this reason, the interest rates and fees associated with them will typically be higher.

Fees from your primary lender

Likewise, if you decide to apply for a second mortgage with another lender, your primary lender will need to consent to this. It is worth noting that if they do agree to this, they will typically charge an administration fee of a few hundred dollars.

Budgetary considerations

It is also worth keeping your own budget in mind. Taking out a second mortgage will mean paying off a separate loan in addition to your primary one. It is worth considering your capacity to make repayments on a second mortgage, and whether this will lead to any financial stress.

Tougher lending criteria

Whenever banks or financial institutions lend money, your financial position and your ability to repay the loan will be key considerations when deciding whether or not to approve your application. Lenders may be stricter in their assessment of your finances if you apply for a second mortgage, as they will want to be confident in your ability to repay the loan.

Buying an investment property

Some people may take out a second mortgage in order to fund the purchase of a second home or investment property. There are potential risks involved in this strategy though, because a downturn in the housing market could reduce the value of one or both of the properties.

When the market value of your property is lower than the balance remaining on your home loan, you are in negative equity. If you wish to understand more about negative equity, including what it is, its potential effects, and potential ways to help avoid it, you can read our explainer here.

What are some alternatives to a second mortgage?

One of the main alternatives to taking out a second mortgage would be to refinance your existing loan instead. Refinancing might typically be a more straightforward process than taking out a second mortgage. Whereas a second mortgage involves taking out another loan (typically with another lender), refinancing typically involves approaching your existing lender and varying the terms of your current loan. You might also switch your mortgage to a different lender and refinance it with them.

One of the main advantages of refinancing is simplicity – you only have one loan to pay off instead of two, and you only have one mortgage on your property. Refinancing can allow you to save money on interest rates, perhaps by switching from a fixed to a variable interest rate, although it is worth keeping in mind that if you switch from a fixed rate loan, your lender might charge you a break fee.

If you wish to use the equity you have in your home to free up some cash, then one option might be a cash-out refinance. A cash-out refinance allows you to draw cash from your equity, typically by agreeing with your lender to replace your old home loan with a new one that has a higher principal than your existing loan. If you opt to do this, then the amount of your loan will be larger, but you will also have the convenience of being able to manage just one loan and mortgage instead of two.

Where can you get a second mortgage?

Depending on your needs and circumstances, if you are thinking of applying for a second mortgage, it may be worthwhile speaking to your existing home loan lender about whether refinancing your existing loan is an option.

Given the nature of second mortgages, many major lenders may be hesitant to offer them. For this reason, if you are seeking one, you may choose to contact a mortgage broker, who may be able to assist you in finding a lender, or call a number of lenders to find out what they may be able to offer.

 

Cover image source: Fizkes/Shutterstock.com


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