One consequence of the interest rate hikes over the past few years is that some homeowners are staying put and tapping the equity in their homes. Given the rapid appreciation in the housing market, many homeowners have large amounts of equity in their homes.
The average U.S. homeowner possessed an impressive $288,000 in equity at the midpoint of 2023, according to CoreLogic. This was a substantial increase from the $182,000 recorded prior to the COVID-19 pandemic. One popular way to access home equity is with a second mortgage.
“Non-QM second-lien mortgages also offer greater creativity in underwriting, making it possible for borrowers with less-than-perfect credit histories or irregular income streams to access equity.”
A second mortgage provides homeowners with a convenient and flexible source of funds. Whether the funds are used to finance home improvements, consolidate debt, subsidize education or secure additional investments, second mortgages are an effective means to achieve personal financial goals.
In 2022, this market expanded with the introduction of a nonqualified mortgage (non-QM) version of a second lien. Non-QM loans are those that cannot be purchased by the federal government or the government- sponsored enterprises, Fannie Mae and Freddie Mac. Conventional and non-QM second mortgages are tools for mortgage originators to help clients meet their financing needs.
Second lien
A second mortgage is a type of loan that is taken out on a property that already has a primary mortgage in place. It is also commonly referred to as a second lien because it is subordinate to the first mortgage. In case of default, the first mortgage lender has priority in recouping their money from the sale of the property.
Because of the existing first mortgage on a property, a second mortgage is taken out against the portion of the home that has already been paid off. A lender will determine how much equity is in the home and will then structure a loan against a portion of it, leaving the first mortgage fully intact.
Second mortgages are popular with borrowers for many reasons. First, unlike other types of loans, the money from a second mortgage can be used for almost any purpose. Second, interest rates on second mortgages are substantially lower than other kinds of consumer debt products. This is why it’s especially appealing to use funds from a second mortgage to pay off high-interest credit cards.
Finally, when a borrower takes out a second mortgage on their home, they can receive the entire amount of the loan in a lump sum at closing. Depending on their circumstances and how they intend to use the funds, this can be particularly advantageous to the borrower.
Informed decisions
Understanding the intricacies of second mortgages is crucial, as it can empower homeowners to make informed decisions and maximize their equity without compromising their long-term financial security. Like any major financial decision, there are pros and cons to consider when borrowing funds in this fashion.
Second mortgages often come with lower interest rates compared to credit cards or personal loans because they are secured by a home’s equity. If the second mortgage funds are used to erase high- interest debt, this can result in significant savings to the borrower.
The interest paid on a second mortgage is deductible, albeit only under certain terms. The type of loan and the amount of debt, as well as the loan origination date, are factors that can determine whether a second mortgage qualifies for a tax deduction. Investing the funds from a second mortgage into home improvements can increase the value of a property, potentially providing a return on investment when the house is sold.
But there are drawbacks. Since a second mortgage is secured by a borrower’s home, failure to make payments could lead to foreclosure. Acquiring a second mortgage means the assumption of more debt. It is crucial for borrowers to ensure they can afford the additional payment without straining their budget.
Obtaining a second mortgage may involve the payment of various expenses, including application fees, appraisal costs and closing costs. These additional fees can increase the overall cost of the loan. A second mortgage also reduces the equity in a home. Economic changes or a decline in the housing market can affect the value of a home, potentially leaving a borrower with less equity than they might have expected.
Another option
For some borrowers who wish to access the equity in their homes, a home equity line of credit (HELOC) might be a more suitable option than a second mortgage. Both types of loans allow homeowners to access money from accrued equity.
A HELOC, however, is substantially different in terms of how funds are accessed, the repayment obligations and other key aspects. A borrower’s home serves as collateral for the loan.
The lender will typically determine the maximum amount that can be borrowed based on a percentage of the home’s appraised value and the remaining first mortgage balance.
The lender will establish a set credit limit, and the borrower can access and repay money as needed within that limit. HELOCs usually have a draw period of five to 10 years. During this time, the borrower is only required to make interest payments on the amount that has been withdrawn.
After the draw period ends, the borrower enters the repayment period. During this phase, no more money can be taken out, and the borrower begins to repay the loan principal and interest. Repayment periods typically last 10 to 20 years. HELOCs are generally offered with variable interest rates, which means that the rate can change over time based on fluctuations in a specified benchmark, such as the prime rate.
Individual situations
Whether a second mortgage or a HELOC is a better option for a homeowner depends on individual financial situations, goals and preferences. There’s no one-size-fits-all answer, as both options have their own advantages and disadvantages.
Second mortgages often come with fixed interest rates, which means that the borrower’s monthly payments remain consistent over time. This can provide more stability and predictability compared to HELOCs, which usually have variable rates.
If your client needs a significant amount of money upfront for a specific purpose, a second mortgage might be more suitable as it typically provides a lump sum. Since second mortgages come with a fixed repayment schedule, it can be easier to budget for these regular payments over the life of the loan. This can be especially beneficial for homeowners who prefer the discipline of consistent payments.
If current interest rates are favorable, a second mortgage with a fixed interest rate can help you lock in the same rate for the entire loan term, protecting the borrower from any future rate hikes. Second mortgages often have longer repayment terms compared to HELOCs. This can result in lower monthly payments, which might be advantageous for homeowners with tighter budgets.
When a borrower takes out a second mortgage, they make a one-time decision regarding the loan amount and terms. This can be appealing if they prefer to secure a specific amount of money without ongoing access to credit like a HELOC.
Greater flexibilty
The introduction of non-QM second mortgages are blazing a new trail for even greater flexibility to tap into home equity. Non-QM second-lien mortgages stand out in the world of lending due to their unique characteristics and flexibility.
Unlike traditional mortgages, these loans do not conform to the stringent guidelines set by Fannie Mae and Freddie Mac. This nonconformity allows lenders to tailor loan terms to individual borrowers, making them an attractive option for those with unique financial situations or nontraditional income sources.
Non-QM second-lien mortgages also offer greater creativity in underwriting, making it possible for borrowers with less-than-perfect credit histories or irregular income streams to access equity. While they may come with slightly higher interest rates to mitigate risk, these loans provide an invaluable alternative for those who wouldn’t otherwise qualify for traditional financing, highlighting their distinctive place within the mortgage market.
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Whether it’s a second mortgage or a home equity line of credit, these loans provide homeowners with access to additional funds, allowing them to finance major expenses or pursue financial goals. Before they choose to go this route, it’s essential to carefully assess your client’s financial situation, compare interest rates and terms from different lenders, and consider the potential risks and benefits. ●
