12 Things Canadians Don’t Know About Second Mortgages
29 March, 2018 / by Glenn Carter
If you’re a Canadian homeowner, you’ve probably heard about second mortgages. But what is a second mortgage? It’s a type of loan that is secured by your home, similar to a first mortgage provided by a traditional bank. Over time you build up equity in your house, and a second mortgage allows you to use the equity you’ve built up.
It is your money after all!
According to Business Insider, there are over “1.91 million Canadians with HELOCs, and even more with a second mortgage.” A HELOC, or home equity line of credit, is a type of second mortgage, as you’re basically adding a second loan on top of your existing loan in order to access equity.
Yet despite their prominence, second mortgages and loans are not well understood or properly leveraged by Canadians. Here are 12 things that you likely didn’t know about second mortgages, which can help you get the most out of an asset that you’ve built equity in.
1. There are different types of second mortgages
What exactly is a second mortgage? These loan products come in a couple of different forms. For instance, a revolving HELOC offers the borrower continuous access to equity as they pay off what they previously owe (the principle), much like how a credit card works.
This type of loan can also be a closed second mortgage, which means that you get one lump sum of cash from your equity, and gradually pay it down, much like an auto loan.
HELOC’s are typically only offered to those in urban areas who have a strong credit profile. If you are experiencing credit challenges or limited income, private mortgages are likely your only option.
2. There are two common uses of second mortgages
The most common usage of a second mortgage is to pay off high-interest consumer debt or to use the funds for home renovations or upgrades. With the average credit card interest rate being 15%, you could save a lot of money by leveraging a second mortgage.
If you have a credit card balance of $30,000, for instance, your minimum monthly payment will be around $600 a month (assuming a 3% minimum payment requirement). If your credit card interest rate is 15% APR, this will cost you about $4,500 in interest in just your first year, before you even touch the principal amount you owe.
So many people are adding a second mortgage, paying off the credit card with that, and then enjoying a much reduced interest rate because a second mortgage is secured by an asset: your home.
3. Your home is collateral
When you take out a second mortgage, you are using your home as collateral to the lender. This means that if you do not pay, the bank has the option to foreclose just as it does with a first mortgage. That said, because you have a physical asset backing your loan, your interest rate will be substantially lower.
4. The power of interest-only payments
For many second mortgage products, you can elect to only make payments on the interest. This creates lower monthly payments, and allows you to have affordable access to the equity in your home before you are ready to sell.
Consider someone who wants to remodel before selling their home or renegotiating their primary mortgage. They can take second mortgage, use those funds to renovate, making interest-only payments. When it comes time to sell or renew, the home is valued at a higher price thanks to the renovations, and then the homeowner pays off the second mortgage.
5. Can be used to avoid PMI
When you apply for a conventional mortgage, if you do not have 20% to use as a down payment you will be required to obtain private mortgage insurance (PMI). In Canada, this is what we typically refer to as your Canadian Mortgage and Housing Corporation (CMHC) fees. And they can be quite high!
On a $500,000 mortgage loan with 5% down, you will be paying 4% CMHC fees. That’s a total of $19,000!
Taking out a second mortgage along with the first mortgage is one way borrowers can avoid PMI. A second mortgage can add a monthly payment to your budget, but can be a cheaper option than PMI.
6. You can use your equity for…Anything!
One of the most attractive benefits of buying a home is the potential to use the equity you have built up over time. Why let it sit there? Let that money you’ve earned start working for you!
You can use the funds however you’d like, but many people choose to use a second mortgage for home improvements, other investments, a child’s college education, an emergency fund, and more.
One popular usage of a second mortgage is to make an investment, like buying a rental property. Instead of saving up 20% for a down payment, you can tap into the equity of your existing home. The bonus of using a second mortgage for investment purposes is that the entire interest on that loan now becomes a tax deduction.
7. How much can I borrow?
That depends on how much equity you have built up in your property. Generally speaking, you will only be able to take out a portion of the of equity you’ve built up. Lenders have restrictions on the loan-to-value (LTV) ratio and take second mortgages into consideration.
For instance, most second mortgages allow you to access up to 80% of the equity you have accumulated in your property (85% in major cities). If you own a property valued at $500,000, and your first mortgage is for $325,000, you’d possibly be able to get access up to $75,000 upon obtaining a second mortgage if you’ve been approved to borrow 80% of the market value of your home. If however, you owed $400,000 on your first mortgage, you wouldn’t be able to access any new funds with a second mortgage approved to 80% LTV, as you’re already at 80% LTV ($400,000 / $500,000)
On the other hand, a closed second mortgage may provide you with access to a greater amount of your equity. Specific questions like this should be addressed with a mortgage broker who specializes in second mortgages.
8. There are some fees
Second mortgages are a great option to keep in mind, but they do come at a price. You’ll need to pay some fees, so be sure to speak with a professional about getting a second mortgage.
9. You and your team MUST compare interest rates
Much like you would with a first mortgage, you should always consider the rates for second mortgages offered by different lenders. This is why working with a professional broker who has access to multiple lenders is your best option.
10. You can consolidate debt
Buried in credit card debt? If you have hefty balances on your credit cards or an enormous pile of student loans to pay back, a second mortgage offers you a way to turn all those high monthly payments into one affordable payment and which can be easier to manage vs. multiple payments with disparate due dates.
You can get a much lower rate on a second mortgage than your credit cards, so this can save you money in the long run and simplify your monthly debt payments, but even when the rate is the same or higher, you can save on cash flow by reducing your monthly payments Most credit cards require up to 3% of the outstanding balance. So if you are only making your minimums, or even worse, missing them! But you have at least 20%+ equity in your home (or more in a rural location) then this is a key sign you should be looking at utilizing that equity.
11. Second mortgages help with bad credit
If you have bad credit, then borrowing money to consolidate or pay off debt can be challenging. Those with poor credit scores often think obtain a second mortgage is impossible, but ironically, this is likely one of the best tools to help them repair that credit.
Gaining access to your equity can allow you to pay off all of those overdue bills, immediately, and give you piece of mind to get your finances back in order.
A simpler, single payment setup, can also make it easier to have a single target to hit monthly.
Most traditional banks, and even many brokers and alternative lenders, do not offer second mortgages for bad credit borrowers. It’s important to speak with a mortgage professional not tied down by these burdensome restrictions, because second mortgages are possible even with a poor credit score. Canada is filled with lenders to work with, and you need someone who will help you find them.
12. Private lenders may have looser qualifying guidelines
If you and your mortgage professional decide to go the route of a private lender for your second mortgage, then you may be subject to less stringent conditions than at a traditional bank. Private lenders are exactly that, private, so they are not bogged down by regulations and internal bank policies, and are therefore much more flexible. This is great for the consumer!
That being said, most private lenders are looking at a mix of items, and so the more you can help make your case why you are a good risk, the better the pricing and overall the more you will be able to borrow in the alternative mortgage market.
A second mortgage is a tool, use it as such
Second mortgages offer you the opportunity to use the equity in your home for a number of different situations. If you have bad credit and need to consolidate debt, pay off other loans, renovate your home, invest, a downpayment on your next property, funds to support yourself while selling, paying off property or tax arrears, or need emergency funds, a second mortgage is a great tool for Canadians to improve their financial well-being. Be sure to consult the right mortgage professional in your area to discuss your specific situation, and how a second mortgage can help you.