Life happens. Not everyone’s situation fits into the same (mortgage) box! If you have been declined by a bank, report limited income, or have bad credit, a Second Mortgage may be a solution for you. Here are the 9 things to consider when getting a 2nd mortgage.
1. What is a 2nd mortgage?
The “second” in a “second mortgage” means the ranking of the number of liens on your property, not how many mortgages you have in total.
For example, if you have a primary residence and an investment property, and you only have one mortgage on each property. Although you have two mortgages, both of them are 1st mortgages as the lenders on those mortgages have 1st ranking on each property.
Lets say you already have one mortgage with a bank. Let’s say your property is worth $1,000,000, and your bank loan is $600,000. You want to borrow more but your bank won’t lend you more money. You then go to a Mortgage Investment Company (MIC) or a Private Lender as they don’t have the same strict rules the banks do. Let assume that a MIC or a private lender loan you an additional $200,000. But, before advancing funds, they will put a 2nd lien on your property for the amount they are advancing.
Long story short, a second mortgage means a second ranking mortgage on a property that has already been mortgaged.
2. What are the interest rates on these mortgages?
Interest rates rates usually range between 6.99% to 12.99% plus 1%~3% up-front fees. Yes, both interest rates and fees have a wide range and depend on a number of factors.
One of the biggest factors that determines interest rates rates is Loan-to-value (LTV). It is calculated as (the total mortgage amount you have on a property) / (the appraised property value).
Using the earlier example:
- 1st mortgage: $600,000
- 2nd mortgage: $200,000
- Appraised value: $1,000,000
In this case, your total borrowing is ($600,00+$200,000)/$1,000,000, as a result you LTV is 80%.
Typical interest rates start at 6.99%-8.99%. The lower the total LTV, the lower will be your rate. If the LTV is between 50%~60%, you may be able to get a rate that’s as low as 6.99% -7.99%. Most lenders stop at 85% LTV. When you go above that, rates increase significantly.
What you have to watch out for are the “up-front” fees. Some lenders lower their “interest rate” to attract borrowers, but they add a hefty “lender fee” on top of that.
For instance, you may be getting a interest rate of 7.99%, but the lender fee may be another 3%. Compared to an interest rate of 8.99% with a lender fee of just 1%, the second option is better. In this case, although the interest rate is higher, the total Cost of Borrowing is lower. See how our mortgage advisors can help you get the best second mortgage and parse out the complex fee structures.
Credit Score and Income
While LTV is the main factor in the lender’s decision for a second mortgage; Credit and Income are the mitigating factors. For a 1st mortgage, for instance, Income and Credit Score are also viewed as more important than the LTV.
If you have steady Income and decent Credit Score, it is likely a lender will lend your more money at the same rate. Or, lower your rate for the same LTV.
Think of the LTV as the “burger” and the Credit Score and Income as the “side of fries”. If the burger is no good, no one is going to come to your burger joint just for the fries. If the burger is average, but the fries are amazing, you may have a case here. Simply put, LTV is the key to determine the amount and the rate of the mortgage you qualify for. But good Credit Score and Income may help.
3. Why are the interest rates higher?
The answer is… it depends. And it depends on what you are comparing it with. When comparing to a first mortgage from a bank, yes, 2nd mortgage rates are higher. However, if you find yourself deep in credit card debt, the rates are often lower than those products.
As you know, unlike the 1st mortgage, where the rates are fairly similar and you pretty much get “approved” or you “don’t qualify”. The rates of the 2nd mortgage vary a lot depending on your Loan-to-value, Credit Score, and Income as discussed above.
The reason why the interest rates are higher is that lenders in 2nd position takes on more risks. As an example, if a borrower defaults on the mortgage, the lenders will have to sell the property. When a property sells, the court will use the proceeds to pay the principle and interest owed to the 1st mortgage lender first, in addition to penalties and lender fees. Whatever is left will be used to pay the 2nd mortgage lender, and the 3rd mortgage lender, if there is one.
Therefore, these lenders need to charge a higher rate to compensate for the higher risks they undertake. As previosuly mentioned, the lower your LTV, the higher your Credit Score and Income, the lower the risk the 2nd mortgage lender is taking, and the lower your mortgage rate.
4. Is there a good reason to get a 2nd mortgage?
It can be a temporary financing solution for a variety of borrowers, such as Real Estate Investors, Business Owners, and people who would like to consolidate their higher interest bearing debts.
Let’s do the (simple) math.
You need to consider both the Cost of Borrowing and Opportunity Cost.
As far as Cost of Borrowing is concerned, Personal Lines of Credit rangs from 4% to 9%, Commercial Loans or Bridge Loans usually have interest rates around 8%-10%, Over Draft Protection Plans and Credit Cards charge an interest rate of 20%, and Pay Day Loans sometimes result in annualized interest rates as high as 300-400% on an annualized basis. Below is a comparison of rates on those products:
And, if you find yourself racking up a balance in any of those products, you may want to consider getting another mortgage to lower your cost of borrowing. It may be a way to help you get out of a debt cycle. Use our Debt Consolidation Calculator to see how you much you can save.
And what is an Opportunity Cost? According to Investopedia, Opportunity Cost represents “the benefits an individual, investor or business misses out”. Therefore, it is very relevant to Real Estate Investors and Self-employed Professionals/Business Owners.
First of all, for a Real Estate Investor, the rental yield plus property appreciation may add up to 20% plus annual return. Unfortunately, most banks have a strict limit on the number of properties and Debt Service Ratio on a rental property. Therefore, if a Real Estate Investor wants to expand the portfolio, one options may be to leverage using a 2nd mortgage on an existing home to purchase a new property. Here’s a good article that goes into greater details on investment property mortgage.
Secondly, second mortgage can be used to support your business. Businesses at the growth stage may give you a return at high teens or even north of 20%, but there may not be enough capital to fuel the expansion. If you turn to Venture Capitalists or Private Equity Firms, they will ask for a big chunk of equity. As entrepreneurs we know how much you cherish your equity. This way of borrowing offers an alternative to grow your business by leveraging your home. If you are looking to finance your home when self-employed, you may also find this comprehensive guide for self-employed mortgage very helpful.
Some people may also borrow money to invest. According to a memo from one of the most celebrated fund managers, Howard Marks (Warrant Buffett indicates he always “learns something” from reading Howard’s memos), as of late March 2020, “given the price drops and selling we’ve seen so far, I believe this is a good time to invest”. Rare investment opportunities like this one presents themselves once in a blue moon – as the memo suggests (when a great opportunity materializes, such like the Dot Com Bubble in 2000’s or the Financial Crisis in 2008, or what we are witnessing now, “no one can argue you should spend all your money (to invest) today…but equally, no one can argue that you shouldn’t spend any”, which is exactly what an Opportunity Cost is.
5. How much can I qualify for?
How much you can qualify when getting a second mortgage is largely dependent on how much your property is worth and your total Loan-to-Value.
For example, you have a property that’s worth $1,000,000 and you already have a 1st mortgage of $500,000 with one of the big banks. And lets assume most second mortgage lenders are able to go up to 85% of the Loan-to-Value; the maximum total amount you can qualify for would be $850,000, which means the second mortgage amount you can potentially qualify for is $350,000.
And just like the determining factors for rates, your Credit Score and Income can also impact how much you can qualify, but Loan-to-Value is really the “deal or no deal” factor.
Depending on their risk tolerance, different lenders are usually comfortable with different Loan-to-Value limits. Some only feel comfortable with up to 70% or below LTV, but others may be willing to lend as much as 95% LTV, at a higher interest rate, of course. That’s why it’s important to find an experienced advisor to match you with the right lender.
6. Will this hurt my credit?
No, if you stay current with your payments.
Unlike Big Banks, many Mortgage Investment Companies (MIC’s) or Private Lenders do not report your payment history to credit bureaus like Equifax or TransUnion. Therefore, even if you are late on your payments, you may not get penalized as much as when you are late on your 1st mortgage. Each lender’s policy and process differ, so it’s best to talk to a mortgage advisor before you apply.
However, if you default, this will likely impact your credit. The general definition of “default” is being late on making your payment for more than 90 days. Again, it varies from lender to lender and from time to time. During the Covid-19 crisis, many major lenders allowed the borrowers to defer their payments for as long as six months, but let’s just call it once in a century event. On the other hand, by law, a lender can “call” the loan as soon as you are 15 days late and start the foreclosure process.
The bottom line is, if you think you MAY default on your loan, whether it’s 1st or 2nd, the advice is to not get one in the first place (or second place).
7. Are these mortgages tax deductible?
Tax treatment of your mortgage is no different whether it’s a first mortgage or a second mortgage. It is based on whether the property is your primary residence or investment property.
As an example, if the property you are financing is a rental property, you are able to deduct your mortgage interest irrepective of the ranking. However, if you are living in the property, your mortgage interest is generally not tax deductible.
It’s also worth noting only the interest portion of your mortgage is tax deductible. For example, if your entire mortgage payment is $2,500/month, out of which $1,000 is interest and $1,500 is principle, you will only be able to deduct the $1,000 interest against your rental income, not the rest. See more tips and tricks on financing a rental property in our Investment Property Mortgage Guide.
8. Can a 2nd mortgage holder foreclose on a property?
Yes. The second mortgage is collagenized on your property just like the 1st mortgage. And if you are late on your 2nd mortgage, the lender will follow the same foreclosure procedures as the 1st mortgage lenders.
If fact, when you are late on your payments, many 2nd mortgage lenders move faster to the foreclosure process compared to the 1st mortgage holders. The reason being is that 1st mortgage lenders are often Big Banks who are very worried about their reputational risk and have complicated processes that may take up to a year to “Serve Notice” to someone in default. The Banks also have more money and equity in the property to “wait” and “work things out”. It’s a different story with smaller lenders, and therefore, it usually takes between 3 to 6 months for a 2nd mortgage lender to enforce on a mortgage.
Keep in mind, a 2nd mortgage should be used to improve your financial situation, not to worsen it. There are plenty of right reasons to get a second mortgages, and a lot of wrong ones. And one should choose very wisely, when it comes to 2nd mortgages.
9. Where to get a second mortgage?
Most of the second mortgage lenders are structured as Mortgage Investment Companies (MIC’s). Some smaller Banks and Credit Unions also offer second mortgages. There are a few things to look out for when choosing a lender:
- Products: Unlike the market for regular mortgages, the second mortgage market is a lot more opaque and fragmented. Many lenders may seem to offer similar products at similar rate. But when you dig deeper, the conditions attached to those products vary widely from one lender to the other.
- Renewal Options: Some 2nd mortgage lenders do not have access to “unlimited money” like the big banks. Therefore, from time to time, they may choose not to renewal your loan if they are short of capital. In most circumstances, you will be able to refinance your mortgage with another lender, but there may be odd cases where a non-renewal may lead to foreclosure if there is no “takers” for your mortgage.
- Fees: Some lenders have a lot of fees embedded in their lengthy loan agreements, which can lead to severe penalties when you pre-pay or when you default on the loan. In other words, be weary of the fine print.
Now you know, getting a second mortgage is not an easy decision. Nor should it be a light one. At Effortless, we have access to the best Private Lenders, and we are committed to offering lowest 1st and 2nd mortgage rates. Talk to us today to see how you can reduce your interest payments with a private mortgage.