Second Mortgage - What is it? Do I Need It?

A second mortgage is a financial tool that is seeing a resurgence among Canadian homeowners. With property values soaring, homeowners are sitting on significant untapped equity in their residences. Property owners are realizing the possibility of consolidating high-interest debts, financing home improvements, or even funding an investment property with a second mortgage. How Does a Second Mortgage Work? A second mortgage is a secured loan taken out against the equity that has been built up in a home. The amount you can borrow through a second mortgage is usually based on the difference between your home’s current value and the amount you still owe on your primary mortgage. Typically, lenders allow homeowners to borrow up to 80 per cent of the appraised value of their home. In the hierarchy of legal claims against a property, a second mortgage is subordinate to a first mortgage. This means that in the event of a foreclosure, the proceeds from the sale of the house would first go toward repaying the primary mortgage. Any remaining funds would then be used to repay the second mortgage. This makes second mortgages riskier for lenders, so they usually have higher interest rates and are given shorter terms. Two Types of Second Mortgages Home Equity Line of Credit (HELOC) A HELOC is a type of second mortgage that works similarly to a credit card. Instead of receiving a lump sum, you’re given a line of credit based on your home’s equity. You can borrow up to this limit for a specified period, known as the draw period (typically 5-10 years), paying interest only on the amount you borrow. A key advantage of a HELOC is the flexibility it offers. You can borrow as much or as little as you need, whenever you need it. They usually have a variable interest rate, which can fluctuate over time. This can be a disadvantage if rates rise, as interest payments can increase. You can look for one with a cap on how much the rate can increase over a specific period. This can provide some protection against rising interest rates. Make sure you fully understand the fees associated with your HELOC. This may include application fees, appraisal fees, up-front charges, closing costs, and annual fees. These can add to the total cost of the loan. After the draw period ends, you enter the repayment period (usually 10-20 years), during which you must repay the borrowed amount in addition to interest. Home Equity Loan (Refinancing Your Mortgage) When you refinance your mortgage, you replace your existing mortgage with a new one, potentially at a different interest rate or over a different term. You can opt for a “cash-out” refinance, which increases the amount you owe but gives you a lump sum of cash that you can use at your discretion. Home equity loans typically have a fixed interest rate, providing predictability in your payments. They also have a fixed repayment schedule, so you’ll make the same monthly payment for the loan term. Should You Invest in a Second Property with a Second Mortgage? Like a primary mortgage, a second mortgage can be classified as good debt if used to increase your net worth or generate additional value. For instance, you might use a second mortgage to invest in a property you plan to rent. If the rental income could more than cover the additional mortgage cost, it pays for itself. Over time, as the property appreciates in value, you can sell it at a profit. It’s important to remember that buying a second property usually requires a significant down payment – at least 20 per cent and sometimes 35 per cent in Canada. So you’d need to have enough equity in your primary home to cover this, plus additional costs like closing costs, ongoing maintenance, and potential periods of vacancy if you plan to rent out the property. Alternatively, you could use a second mortgage for substantial home improvements. Certain home improvements can increase the value of your home, giving your second mortgage a good return on investment. Both a HELOC and home equity loan can be beneficial, depending on your needs. A HELOC is great if you need flexibility and smaller, intermittent funds. A home equity loan is suitable for significant, one-time expenses like a major renovation, debt consolidation, or investment property.

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