A second mortgage is a loan, in addition to your primary mortgage, that uses your home as collateral. Any homeowner who has 20 percent equity in their property and a decent credit score can get approved for a second mortgage in the form of a home equity loan or line of credit. While it might be easy to get approved for a new loan, it's important to understand when you should take out a second mortgage and when you should look for alternate ways to pay for expenses.
Why Do You Need a Second Mortgage?
From paying off debt, to sending a child to college, to going on a killer vacation, reasons people take out second mortgages vary tremendously.
A second mortgage can be a good idea if it means furthering future wealth in some way. Many investors use this money to buy income properties or start small businesses that will generate profit. Using a second mortgage to obtain an advanced degree that offers higher salary potential might also be an excellent use of a low-interest loan.
Taking on debt to fund things you can't afford to pay for in cash but want right now does not help improve your bottom line. Before using a second mortgage to pay for lifestyle upgrades, ask yourself: Are you okay to still be paying off this year's vacation or new refrigerator in 10 years?
Using a Second Mortgage to Pay Off Credit Card Debt
For people struggling with consumer debt, taking out a second mortgage to pay off credit cards can mean lower payments at a lesser interest rate. However, that strategy is not a good idea unless you first change the behavior that caused the debt in the first place. Otherwise, having available credit might tempt you back into debt - with the addition of having a new mortgage payment.
While money from a second mortgage might seem like a good idea in the current low interest rate climate, it's important to remember that your primary residence is securing the loan. Could you still make mortgage payments if you lost a job or had an extended illness?
No one wants crushing credit card payments, but if you default on consumer debt, the worst that happens is getting calls from creditors and taking a huge hit to your credit score. Credit card companies can't physically take anything away. Defaulting on a second mortgage could mean losing your home.
A Second Mortgage to Avoid PMI
Private mortgage insurance or PMI, is that pesky monthly fee that homeowners have to pay if their down payment was less than 20 percent. In some situations, taking out a primary mortgage for 80 percent of the loan and using a home equity loan and a smaller down payment to fund the balance can eliminate PMI. Just be sure that the costs of the second mortgage aren't more than the cost of paying PMI.
Alternatives to Taking a Second Mortgage
If you aren't sure that a second mortgage is a good idea, you have options. It might be possible to refinance your home into a lower interest rate or longer loan term without adding extra debt. If you have a large amount of home equity, it could be a good idea to sell your current home and downsize to a more affordable living situation. Lowering your monthly house payment can free up money to use for expenses or investments.
Increasing Income Instead of Adding Debt
Finally, most people can make more money if they are willing to take on more hours at work or add a side job. In many cases, it's well worth the effort to increase income to afford an upcoming expense rather than increasing debt with a second mortgage or other loan.
Whether or not you should take out a second mortgage is something that should be carefully considered. If borrowing more money means increasing wealth, it can be a good way to leverage debt to your advantage. If more debt means risking your home, it's probably not a smart idea.
Kim Parr is an author who writes about achieving financial success on Eyes on the Dollar.