First mortgages are taken out when a home is first purchased, while second mortgages are taken out some time later, when the equity in the house has increased. Therefore, the purpose of the second mortgage is not to finance the purchase of the home.
Usually, homeowners will take out a second mortgage to undertake some renovations or improvements to the property, but increasingly, people are using the equity in their homes to reduce or eliminate their high rate credit card debt.
If you are thinking about taking out a second mortgage for home improvements, you should be sure you are going to get that additional value. Adding a bedroom, or renovating a kitchen are projects that have proven to make a home more valuable since these are items that new home buyers look for.
Unnecessary home improvements, such as an in ground pool, may not be as attractive to potential buyers, and would therefore not be considered a good reason for a second mortgage.
Today, it is considered a smart financial move to reduce or eliminate high consumer debt and replace it with lower rate debt taken from the increased value of the home. Typically the interest rate on credit cards can be 16 to 20% or more, while a second mortgage can be obtained at 5-9%, representing a substantial overall savings to the homeowner.
Creating more debt that is not going to either add value to your home, or reduce your present high interest debt is not a good economic decision.
Since a first mortgage is paid off from the proceeds of the home in case of default, there may not be sufficient equity in the home to pay the second mortgage, and this is the risk the second mortgage lender takes.
It is for this reason that second mortgages have higher interest rates than first mortgages. One of the factors determining interest rates is risk, and since the bank granting the second mortgage has a higher risk because the mortgage will not be paid off unless the first mortgage is paid off, this is reflected in the rate.
There are closing fees associated with all mortgages, but the closing fees for second mortgages are typically higher than for first mortgages. Be conscience of all of the costs so that you can compare it to the benefit you plan to receive (the amount of increased home value, or the savings on credit card debt.)
It really pays to shop around for a second mortgage, since the rates can vary a great deal. You should also shop around for the lowest closing costs. Closing costs for a second mortgage are a proportionately greater cost since the loan is typically for a smaller amount than a first mortgage.
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