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How to Choose the Best Second Mortgage While Minimizing Risk

Updated: Dec 14, 2023

For most people, their home is their greatest asset. Borrowers can use the equity in their home to make financial decisions that include paying down credit card debt or repairing or remodeling their home. Consumers accrue equity by paying off their primary mortgage. Essentially, borrowers use their home as collateral.

There are two types of second mortgages: home equity loans and home equity lines of credit (HELOCs). There are subtle differences between these products. Homeowners are taking on more debt and this addresses the need for risk assessment. HELOCs and home equity loans tend to have a higher interest rate than primary mortgages.

The primary goal for borrowers is to build home equity. This can be adhered to by following these guidelines; (1) make a large downpayment; (2) avoid private mortgage insurance; (3) increase your monthly payment in order to pay down the principal balance; (4) refinance to a shorter loan term; (5) increase the value of your home through upgrades such as remodeling your kitchen or installing energy efficient products such as windows.

When should a homeowner seek a second mortgage? These products have lower interest rates than credit cards, so they are a viable option for paying down credit card debt. You can transfer the balances on your credit cards to your HELOC. Consumers can consolidate their revolving debt into a single monthly payment at a lower interest rate. 

What are the most common uses for home equity loans? Often, consumers use this product to make home improvements, start a company, or pay for college tuition. What is the most common use for a HELOC? Many consumers use this product for home improvements and to pay down credit card debt - borrowers can typically withdraw from HELOCs for ten years with a 20 year repayment period.

When you borrow against the equity in your home, there could be a financial benefit – the interest you pay each year is tax-deductible up to a government imposed limit. These funds must go towards improving your home. Claiming this deduction is easy – simply deduct the interest paid on your home equity loan or HELOC. Borrowers can itemize deductions at tax time by utilizing IRS Form 1040.

Borrowers should proceed cautiously when their home is their only real asset. While a HELOC can function as a long-term solution, borrowers need to remember that they could become overextended and this could lead to foreclosure. Furthermore, borrowers must research upfront expenses that include a home appraisal and a title fee. There are origination costs and closing fees as well.  These collective expenses can cost thousands.

To receive a loan or a HELOC, lenders analyze equity, credit scores, and debt-to-income ratios. Equity is the appraised value of your property minus the sum of payments applied towards your primary mortgage. Your credit score consists of a numerical ranking based on your credit history that indicates your ability to repay a loan. A good credit score is 680. Your debt-to-income ratio divides your total monthly debt payments by your gross monthly income. A good ratio is 36%.

Lenders evaluate these factors to determine risk assessment, and these categories have monetary thresholds. Depending upon your financial history, lenders could allow you to borrow up to 85% to 90% of your home equity through a loan or a line of credit.

These products cost more because the lender is taking on additional risk. Essentially, borrowers will be making two mortgage payments per month. While second mortgages carry higher interest rates than primary mortgages, they usually offer a low interest rate when compared to other products such as personal loans. Borrowers should thoroughly research their financial options in order to get the best value for their money. Consumers need to focus on risk assessment and risk mitigation.

Considering home equity loans, borrowers will receive their loan amount in a lump sum and they will make monthly payments for the same dollar amount every month. These loans are often fixed-rate products, so your interest rate remains the same for the duration of the loan. These payments include principal and interest.

On the other hand, HELOCs are a revolving line of credit. While the interest rate on HELOCs generally fluctuates month to month, borrowers can negotiate a fixed rate line of credit. Some lenders allow borrowers to carve out a portion of the debt owed on their HELOC in order to convert this sum to a fixed rate.



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