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Second Mortgages - Fixed Rate vs. HELOC
(Home Equity Line Of Credit)
By Brent Bourdeau
Partner at Elliott Bay Mortgage
A second mortgage is a loan that is secured by a deed of trust in second
lien position. It is often times, if not always, tax deductible so it can
be a great way to efficiently access equity in one’s home. Second
mortgages can also be used as a down payment on a purchase of a home. The
trick is to evaluate if and when they make sense, and which type is right
for you.
Let’s explore the two different types of second mortgage loans. They each
have very different uses and applications, and they also have
significantly different risks associated with them.
Fixed Rate Second Mortgage
This loan is, for the most part, exactly what the name would suggest. It
comes with a fixed interest rate for 5, 7, 10, 15, or even 30 years. It’s
a great loan if you’re looking to set a payoff term on something, or if
you’re buying a home and you want to eliminate mortgage insurance on your
payments. There are some that will even offer an initial Interest Only
period on the loan to help make it more affordable. Often, these loans
will have a small penalty when you pay them off, typically around 1% of
the loan amount or $500, whichever is smaller. Different variants of this
loan have 30 year amortizations with balloon payments at 5, 7, or 10 years
with lower rates.
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Home Equity Line Of Credit (HELOC)
This type of loan is a little more complex. It’s a loan that will
have a 20 or 30 year term, with the first 10 years being interest
only payments on the balance. They are variable rate loans based on
the Prime Rate (currently 8.25%), so they go up and down with the
market. The great thing about this loan is that it works much like a
credit card. You can pay it down, and then borrow against it later
at will. They are perfect for that remodel project where you “pay as
you go,” and you only pay on the amount that you have outstanding.
HELOCs have a low payment and are an efficient way of using funds
typically for the short term.
Two major factors affect the rates of
second mortgages. They would be the borrowers’ credit scores and
Cumulative Loan to Value (CLTV) calculations. Someone with a 720
credit score and someone with a 679 credit score can likely both get
a loan, but the rate may vary by 1% or more in this scenario. This
can be a significant figure, depending on the amount of the second
mortgage. The Cumulative Loan to Value (CLTV) ratio can bump rates
up quickly. |
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CLTV is calculated as: (Home Value) /
(Total Loans)
If you have a CLTV of 80% your rate might be 1% lower than on a CLTV of
95%. On a large loan, this adds up quickly. Based on this information, the
resulting pricing then determines the affordability of the loan, and that
is where we determine if it makes sense to do a second mortgage, or just
refinance the primary mortgage and pull cash out.
One thing to note is that many times, second mortgages are not permanent.
For instance if you were to put $100k into a kitchen, and used a HELOC to
facilitate this project: Once you complete the project, your home’s value
has increased. You would then likely consider refinancing the primary
mortgage together with the HELOC to eliminate the risk of the HELOC’s
variable rate. This also reduces the overall rate you were paying for both
loans… which means lower payments.
Another example would be the purchase of a new home. Coming up with a 20%
down payment can be quite difficult, especially for a first time
homebuyer. Anytime someone borrows over 80% of the value on a home,
Mortgage Insurance is required. One way to get around this is to buy the
home with a first mortgage at 80% of the value, and do a second for the
remainder. This eliminates the need for mortgage insurance at the time of
closing, and can save $50 to $200 per month on payments! After 2, 3, or 4
years, there might be enough equity to combine the loans at under 80% of
the value and just have a single lower payment, and not once having to pay
mortgage insurance.
There are many things to consider when looking at second mortgages. To get
a good understanding of what makes sense, or for more information, please
feel free to call and I would be happy to assist you in figuring out a
plan that meets your needs.
Brent Bourdeau
Copyright © 2007 Brent Bourdeau
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