Selling a Home

Home Equity
and Second Mortgage

Your home is an asset, and over time, that asset can gain value. One of the biggest perks of homeownership is the ability to build equity over time. Home equity is typically a homeowner’s most valuable asset. That asset can be used later in life, so it’s important to understand how it works and how to use it wisely. You can use that equity to secure low-cost funds in the form of a second mortgage—either a one-time loan or a home equity line of credit (HELOC.)

Home equity can increase or decrease, but ideally, it grows over time. Home equity can change in a variety of ways. When you make monthly payments on your loan, you reduce your loan balance, increasing your equity. If your home gains value because of a strong real estate market or improvements you make to your home, your equity increases. On the other hand, you lose equity when your home loses value, or you borrow against your home.

Calculating Your Home’s Equity

Start with your home’s current value and subtract the amount owed on any mortgages or other form of security interest granted over an item of property known as liens. Those mortgages might be purchase loans used to buy the house or second mortgages that were taken out later. Your lender doesn’t own any portion of the property unless you’ve obtained a shared equity mortgage, which is relatively uncommon. You own everything, but the house is being used as collateral for your loan. Your lender secures its interest by getting a lien on the property. You can calculate your equity stake by dividing the loan balance by the market value, then subtracting the result from one and converting the decimal to a percentage.

Luckily, your home equity grows in proportion to the price of your home, and this is something you can grow. You can also actively work to increase your home’s value through improvement projects. When the real estate market is healthy and growing, then house prices rise, and you’ll build equity naturally.

Repaying Your Loans

As you pay down your loan balance, your equity increases. Most home loans are standard amortizing loans with equal monthly payments that go toward both your interest and principal. Over time, the amount that goes toward principal repayment increases and you build equity at an increasing rate each year. If you happen to have an interest-only loan or another type of nonamortizing loan, you don’t build equity in the same way. You may have to make extra payments to reduce the debt and increase equity.

Accelerate Your Equity

A way to build home equity faster is through accelerated mortgage payments. Using this approach will shave off a considerable amount of interest paid over the course of the loan and will allow you to pay off the mortgage in a significantly shorter time frame. This also means you’ll be building equity faster. Before you decide to start making bi-weekly payments first check with your lender to make sure this is the right choice for you. You’ll want to make sure you haven’t taken on too much and force yourself to backtrack into a worse deal.

A Home Equity Loan

With a home equity loan, you get all the money at once and repay in flat monthly installments throughout the life of the loan. This timeline can range from five years to fifteen years or more. You’ll have to pay interest on the full amount, but these types of loans may still be a good choice when you’re considering a large, one-time expenditure including paying for a full rehab of your home, consolidating higher-interest debts, or buying your dream vacation. Your interest rate is usually fixed with a home equity loan, so there will be no surprising rate hikes later, but note that you’ll likely have to pay closing costs and fees on your loan.

A Second Mortgage

A second mortgage is a way to use the equity of your home to gain funds you can use for other projects and goals. It is another loan taken against your property that is already mortgaged. Second mortgages tap into the equity in your home, which is the market value of your home less any loan balances. A second loan, or mortgage, against your house will either be a home equity loan, which is a lump-sum loan with a fixed term and rate, or a HELOC (home equity line of credit), which features variable rates and continuing access to funds.

Second mortgages can come in different forms. First, a standard second mortgage is a one-time home equity loan that provides a lump sum of money you can use for whatever you want. With this type of loan, you’ll repay the loan gradually over time, often with fixed monthly payments. With each payment, you pay a portion of the interest costs and a portion of your loan balance in a process called amortization. Secondly, it’s also possible to borrow using a line of credit, or a pool of money that you can draw from. With this type of loan, you’re never required to take any money—but you have the option to do so if you want to. Your lender sets a maximum borrowing limit, and you can continue borrowing until you reach that maximum limit. As with a credit card, you can repay and borrow over and over.

Advantages of Second Mortgages

There are great advantages to a second mortgage. The allow you to borrow significant amounts because you have access to more than you could get without using your home as collateral. Second mortgages also often have lower interest rates than other types of debt. Securing the loan with your home helps you because it reduces the risk for your lender. Because the loans are lower risk, lenders offer lower rates on second mortgages than unsecured personal loans like credit cards. In some cases, you’ll be able to take a mortgage interest deduction for interest paid on a second mortgage.

Disadvantages of Second Mortgages

Benefits always come with trade-offs. The costs and risks mean that these loans should be used wisely. Second mortgages come with the risk of foreclosure. If you stop making payments, your lender will be able to take your home through foreclosure, which can cause serious problems for you and your family. Loan costs and interest costs are another disadvantage of a second mortgage. You’ll need to pay numerous costs for things like credit checks, appraisals, origination fees, and more. Closing costs can easily add up to thousands of dollars. Second mortgage rates are typically lower than credit card interest rates, but they’re often slightly higher than your first loan’s rate.

Common Uses of Second Mortgages

Consider how you plan to use the funds from your loan. It’s best to put that money toward something that will improve your net worth, or your home’s value in the future. This is because you’ll need to repay these loans, they’re risky, and they cost a lot of money.

Renovations are a common use for second mortgage funds because the assumption is that you’ll repay the loan when you sell your home with a higher sales price. You can often get a lower rate with a second mortgage, but you might be switching from unsecured loans to a loan that could cost you your house. Paying for education is another reason you would consider a second mortgage. You may be able to set yourself up for a higher income. But as with other circumstances, you’re creating a situation where you could face foreclosure. Standard student loans come with a low interest rate and might be a better option.

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