Second mortgage
Second mortgages, commonly referred to as junior liens, are loans secured by a property in addition to the primary mortgage. Depending on the time at which the second mortgage is originated, the loan can be structured as either a standalone second mortgage or piggyback second mortgage. Whilst a standalone second mortgage is opened subsequent to the primary loan, those with a piggyback loan structure are originated simultaneously with the primary mortgage. With regard to the method in which funds are withdrawn, second mortgages can be arranged as home equity loans or home equity lines of credit. Home equity loans are granted for the full amount at the time of loan origination in contrast to home equity lines of credit which permit the homeowner access to a predetermined amount which is repaid during the repayment period.
Depending on the type of loan, interest rates charged on the second mortgage may be fixed or varied throughout the loan term. In general, second mortgages are subject to higher interest rates relative to the primary loan as they possess a higher level of risk for the second lien holder. In the event of foreclosure, in which the borrower defaults on the real estate loan, the property used as collateral to secure the loan is sold to pay debts for both mortgages. As the second mortgage has a subordinate claim to the sale of assets, the second mortgage lender receives the remaining proceeds after the first mortgage has been paid in full and therefore, may not be completely repaid. In addition to ongoing interest repayments, borrowers incur initial costs associated with the origination, application and evaluation of the loan. The charges related to the processing and underwriting the second mortgage are referred to as the application fee and origination fee respectively. Borrowers are also subject to additional costs which are charged by the lender, appraiser and broker.
When refinancing, if the homeowner wants to refinance the first mortgage and keep the second mortgage, the homeowner has to request a subordination from the second lender to let the new first lender step into the first lien holder position. Due to lender guidelines, it is rare for conventional loans for a property having a third or fourth mortgage. In situations when a property is lost to foreclosure and there is little or no equity, the first lien holder has the option to request a settlement for less with the second lien holder to release the second mortgage from the title. Once the second lien holder releases themselves from the title, they can come after the homeowner in civil court to pursue a judgement. At this point, the only option available to the homeowner is to accept the judgment or file bankruptcy.Second mortgage types
Lump sum
Second mortgages come in two main forms, home equity loans and home equity lines of credit. A home equity loan, commonly referred to as a lump sum, is granted for the full amount at the time of loan origination. Interest rates on such loans are fixed for the entire loan term, both of which are determined when the second mortgage is initially granted. These close ended loans require borrowers to make principal-and-interest repayments on a monthly basis in a process of amortisation. The interest repayments are the costs associated with borrowing whilst the principal paid reduces the loan balance. With each subsequent repayment, the total amount remains constant however the portion related to the interest cost decreases whilst the amount corresponding to the principal increases. This ensures the loan is completely paid off at the end of the payment schedule. Home equity loans are commonly used for debt consolidation or current consumption expenditures as there is generally lower risk associated with fixed interest rates.Line of credit
Home equity lines of credit are open ended loans in which the amount borrowed each month may vary at the homeowner's discretion. These loans offer flexible repayments schedules and are subject to variable interest rates that may potentially increase or decrease during the loan term. Borrowers have access to the line amount which is predetermined at the time of loan origination but are not required to draw amounts if they do not wish to. The revolving credit facility provides borrowers the flexibility of drawing down amounts only when required to avoid interest on unnecessary credit. This ensures a minimum debt level is maintained as monthly repayments correspond only to the amounts used rather than the full amount available. Home equity loans are commonly used when borrowers anticipate future consumption expenditures as well as credit shocks which affect access to credit in the future.Second mortgage loan structure
Standalone second mortgage
Second mortgages can be structured as either a standalone deal or a piggyback loan. Standalone second mortgages are opened subsequent to the primary mortgage loan to access home equity without disrupting the existing arrangement. Typically, the home buyer purchases a primary mortgage for the full amount and pays the required 20 percent down payment. During the loan term, monthly mortgage repayments and appreciating real estate prices increase the property's equity. In such instances, standalone second mortgages are able to use the property's equity as collateral to access additional funds. This financing option also offers competitive interest rates relative to unsecured personal loans which reduce monthly repayments. With reference to unsecured personal loans, lenders are exposed to a greater level of risk as collateral is not required to secure or guarantee the amounts owed. If the borrower were to default on their repayments, the lender is not able to sell assets to cover the outstanding debt. Accordingly, second mortgages not only ensure access to greater amounts but also lower interest rates comparative to unsecured loans. With increased cash flow, second mortgages are used to finance a variety of expenditures at the discretion of the borrow including home renovations, college tuition, medical expenses and debt consolidation.Piggyback second mortgage
Piggyback second mortgages are originated concurrently with the first mortgage to finance the purchase of a home in a single closing process. In a conventional mortgage arrangement, homebuyers are permitted to borrow 80 percent of the property's value whilst placing a down payment of 20 percent. Those unable to obtain the downpayment requirement must pay the additional expense of private mortgage insurance which serves to protect lenders during the event of foreclosure by covering a portion of the outstanding debt owed by the buyer. Hence, the option of opening a second mortgage is specifically applicable to buyers who have insufficient funds to pay a 20 percent down payment and wish to avoid paying PMI. Typically, there are two forms in which the piggyback second mortgage can take. The more common of the two is the 80/10/10 mortgage arrangement in which the home buyer is granted an 80 percent loan-to-value on the primary mortgage and 10 percent LTV on the second mortgage with a 10 percent down payment. The piggyback second mortgage can also be financed through an 80/20 loan structure. In contrast to the previous method, this arrangement does not require a down payment whilst still permitting home buyers 80 percent LTV on the primary mortgage and 20 percent LTV on the second mortgage.Repayment
Ongoing interest repayments
Varying interest rate policies apply to different types of second mortgages. These include home equity loans and home equity lines of credit. With regard to home equity loans, lenders advance the full amount at the time of loan origination. Consequently, homeowners are required to make principle-and-interest loan repayments for the entire amount on a monthly schedule. The fixed interest rate charged on such loans is set at the time of loan origination which ensures constant monthly repayments throughout the loan term. In contrast, home equity lines of credit are open-ended and based on a variable interest rate. During the borrowing period, homeowners are permitted to borrow up to a predetermined amount which must be repaid during the repayment period. Whilst variable interest charges may permit lower initial repayments, these rates have the potential to increase over the duration of the repayment period. Second mortgage interest rate payments are also tax deductible given certain conditions are met. This advantage of second mortgages reduces the borrower's taxable income by the value of the interest expense. In general, total monthly repayments on the second mortgage are lower than that of the first mortgage. This is due to the smaller amount borrowed in the second mortgage compared to the primary loan rather than the difference in interest rate. Second mortgage interest rates are typically higher due to the related risk of such loans. During the event of foreclosure, the primary mortgage is repaid first with the remaining funds used to satisfy the second mortgage. This translates to a higher level of risk for the second mortgage lender as they are less likely to receive sufficient funds to cover the amounts borrowed. Consequently, second mortgages are subject to higher interest rates to compensate for the associated risk of foreclosure. They are also commonly used in Canada when borrowers wish to access home equity without altering the interest rate, amortization, or maturity date of an existing first mortgage.Closing costs
Second mortgagors are subject to upfront fees associated with closing cost of obtaining the mortgage in addition to ongoing payments. These include application and origination fees as well as charges to the lender, appraiser and broker. The application fee is charged to potential borrowers for processing the second mortgage application. This fee varies between lenders and is typically non-refundable. The origination fee is charged at the lender's discretion and is associated with the costs of processing, underwriting and funding the second mortgage. Also referred to as the lender's fee, points are a percentage of the loan that is charged by the lender. With each point translating to one percentage of the loan amount, borrowers have the option to pay this fee in order to decrease the loan interest rate. Whilst paying points increases upfront payments, borrowers are subject to lower interest rates which decrease monthly repayments over the loan term. Second mortgages are dependent upon the property's equity which is likely to vary over time due to changes in the property's value. Professional appraisers who assess the market value of the home result in an additional cost to potential borrowers. A broker fee, associated with the service of providing advice and arranging the second mortgage, is also incurred by borrowers.