For the majority of individuals, home ownership represents their largest financial undertaking. You spend years working hard, saving your money, and finally get to the point where you can make that down payment on your dream home. In the United States, our financial system allows individuals to purchase their home without the need to have the entire purchase price saved up. By allowing the buyer to put a down payment on the home, and then carry a loan or mortgage to be paid back for the remainder of the balance over a number of years (generally 15 years or 30 years), home ownership is able to be more readily achievable for individuals.
The idea of a mortgage can be very favorable, as it allows more individuals to own their own home sooner rather than later and help secure their financial future (as the trend is for real estate to appreciate over time). When your property appreciates over time, that increase in value over your original purchase price less your remaining loan balance can provide you with additional financial security and opportunities. For example, many choose to sell their home that has increased in value and purchase a new home, or others may use the increased value for other reasons, such as performing home improvements or consolidate other debt and pay for a child’s tuition expenses. This is done by way of taking a second mortgage on your home. However, it is important to note that second mortgages can also lead individuals in a financial position where they risk the possibility of losing their home as well.
What is a second mortgage?
A second mortgage is a loan that an individual is able to take out against the equity that has accumulated in their home. It provides a homeowner with a way to tap into needed funds as the equity increases in their home. Equity will increase in a home in a few different ways: (1) equity increases in the home as it appreciates in value based on your area's current real estate market (historically real estate tends to appreciate over time), (2) equity increases in your home as you pay down the principal balance on the loan (generally the early years of mortgage payments go towards interest and less towards principal, however later year of payments will pay down more of the principal balance and increase equity) or (3) equity will increase in your home as real estate appreciates and you continue to pay down your mortgage principal.
Second mortgages offer great spending flexibility as to how the funds can be used, and generally do not carry any restrictions on use. Since the funds received from a second mortgage are flexible, many individuals will choose to take out a second mortgage to fund various things such as pay to remodel their home (i.e. update bathrooms and kitchen), make improvements such as adding an addition to the home, complete much needed repairs and general maintenance on the home, pay for education expenses (i.e. to further your own or your spouse's education, or possibly a child’s college tuition), buy investment property/second home (the equity can allow you to continue to secure additional streams of income, like becoming a landlord, to consolidate higher interest debt, and lastly, some individuals choose just to have the money quickly and easily accessible in case of an emergency (i.e. hospital bills or other unforeseen event). With a second mortgage, the home serves as collateral for the loan, and is placed in a second or junior-lien position below your primary mortgage which holds the first-lien position against the property.
The purpose of securing a lien against the property is to protect the lender’s interest in the event that you default on your repayment obligations. To further protect themselves, a lender for a second mortgage will request proof of income in order to determine that you are able to make your primary mortgage payment as well as the second mortgage. It is important to understand that you will now have two mortgage obligations, the original primary mortgage plus the new second mortgage. (Note, it is possible to take on additional mortgages after a second, depending on if additional equity has increased in the property and you are able to make your repayment obligations).
Since the addition of a second mortgage will now bring along with it the obligation to be responsible for two mortgages at the same time (the primary mortgage plus second mortgage), defaulting on either one or both loan responsibilities can result in your primary lender or secondary lender pursuing foreclose to recoup the outstanding balance of the respective loan. In a foreclosure, the home will be auctioned off to the highest bidder and the sale proceeds will first be used to pay your primary mortgage who holds the first-lien position. After the primary lender has been paid, any remaining proceeds will then be used to pay the second mortgage. Since there is a risk that the second mortgage lender may not receive the full value of the loan from the foreclosure proceedings, they will generally charge a higher interest than a primary mortgage to compensate for the increased risk that you will not be able to maintain two mortgage obligations. A second mortgage lender will further reduce this risk by only loaning up a certain percentage of your available equity, instead of lending up to the maximum amount of your total available equity.
The Various Types of Second Mortgages
Although there are several types of second mortgage options available to homeowners, we will focus on the two most common and relevant types below:
- Home equity line of credit (HELOC) - A home equity line of credit, commonly referred to as a HELOC is one of the most popular choices for those looking to tap into the equity that has accumulated over time in their home. A HELOC functions as a line of credit and allows you to draw funds as needed. You are only responsible to pay back the amount that you withdraw according to the terms of your agreement. This means that you can draw a portion of the available HELOC amount, and pay interest only, or interest and principal on the withdrawn amount. As you repay the principal amount, you increase the amount of overall funds available for a later time. You are not required to draw any or all of the funds, but they are available to you when needed. HELOC’s offer flexible repayment terms, such as interest only payments for up to 10 years, and then the balance of interest and principal to be repaid over 15 or more years like a traditional mortgage. In a way, HELOC functions much like a credit card, as you have an available amount, and as you draw on that amount, you repay your outstanding balance, which will determine how much of the original loan amount you have for later use. It is important to note that the interest rates attached to the HELOC interest-only period are variable, meaning they can increase or decrease with the market. This can make it difficult to make your payment obligation if your rate increases beyond your financial means. When you enter into the repayment portion of interest and principal, the HELOC will usually have a fixed interest rate like a traditional loan. Further, since you are not required to draw funds, some people like having a HELOC ready for an emergency. The money is readily available if and when it is needed.
- Home equity loans - A home equity loan is another common form of a second mortgage. A home equity loan functions much like a traditional mortgage. You will apply and qualify for a set amount with set repayment terms (length of loan and interest rate). If you agree to the terms of the loan, you will receive a one-time lump sum and are required to then make payments on the borrowed amount just as you would on your primary mortgage. Unlike a HELOC which offers interest only payments, a home equity loan will have a fixed payment of principal and interest due every month. There is no revolving credit line to receive funds after the initial lump sum. Because a home equity loan requires both payment of principal and interest, the interest rate is generally fixed, and higher than a primary mortgage, as there is increased risk that you may not meet your repayment obligations.
What is equity and how it is calculated?
Equity refers to the market value of your home in relation to any outstanding loan balances. Since market value can increase or decrease over time, your equity can fluctuate as well. For example, if your home has a market value of $150,000 and you have an outstanding mortgage for $50,000, then you have $100,000 in equity. As you continue to pay down the principal balance on the home and or the real estate market continues to appreciate, you will have more equity available in your home. It is this built up equity that allows you to take out a second mortgage and use those funds as you see fit. The lender is lending based on the equity in your home and thus will secure the home as collateral for repayment.
In the ideal scenario, your equity in your home will increase over time. However, equity can increase and decrease from varying factors. For example, equity increases as you continue to pay down your principal balance on your mortgage, by making improvements to your home that increase its market value, and from an increase in the real estate market. As real estate values increase, so does the amount of equity you have. By comparison, your equity in your home can decrease as you increase your debt burden by borrowing against your home and by declining real estate market values. This is why some individuals choose to apply for a HELOC and have the funds sit unused in an account if needed, as the HELOC amount may have been based on greater equity than now exists in your home.
Ways to use a funds from a second mortgage
As previously mentioned, there are several reasons why people take on the added responsibility of having a second mortgage. Since the use of the funds from a secondary mortgage are not restricted, they can be used for many purposes. Most common uses include paying for home improvements projects, completing much needed home repairs like fixing the roof, for investments such as purchasing income producing property or secondary/vacation home, paying for education expenses, medical bills, and consolidating higher interest debt, such as credit card debt.
Relief options when you have defaulted on your second mortgage?
Unfortunately, it is not uncommon for a homeowner to find themselves falling behind on their mortgage and their home value being under water due to owing more debt than their home is worth. The major pitfall when taking on a second mortgage is the obligation of now being responsible to make two loan payments instead of just one primary mortgage payment. As mentioned previously, it may become difficult to make both mortgage obligations if you have a decrease in your income, home values have decreased and your variable interest rate has skyrocketed beyond your ability to pay.
If and when a homeowner finds themself in a position where they can no longer make payments on the second mortgage, they must decide if any options exist to allow them to keep their home while now decreasing or possibly eliminating being responsible for the second mortgage. This is where consulting with an experienced attorney such a Modesto Bankruptcy Attorneys can prove to be pivotal. Prior to contemplating bankruptcy, our attorneys will evaluate your specific circumstance to evaluate if they can resolve your matter and avoid filing for bankruptcy relief. At Modesto Bankruptcy Attorneys, we have the experience to handle your second mortgage obligations by doing the following:
1. Negotiating with your lender
- It is possible that you find yourself in a position where you can continue to make payments on your primary mortgage, but can no longer afford payments on your second mortgage. Since you are unable to keep paying both mortgages, you stop paying the second mortgage and risk the second mortgage lender foreclosing. If feasible, our attorneys are able to negotiate the balance of your second mortgage down, decrease your interest rate, get a temporary forbearance to allow you time to get your finances back in order (for example, if you lost your job and have prospects for new employment) and even get the lender to agree to a payment plan. This would allow you to continue staying current on your primary mortgage and keep your home.
For illustration, let's assume you owe $50,000 on your second mortgage and can no longer afford the payment. However, you are able to continue paying your monthly primary mortgage. Our attorneys could use their skill set and potentially be able to negotiate the $50,000 secondary mortgage down to a smaller sum, for example, $25,000 and stretch the payments over 3-5 years. Once you are complete on your payment plan, your debt obligation is satisfied in full.
2. Stripping the second mortgage in Chapter 13 bankruptcy
- If you find yourself in a circumstance where negotiating with your lender proves to be either not feasible or unsuccessful, filing for Chapter 13 Bankruptcy may allow you to modify or eliminate the mortgage and still allow you to keep your home. When the value of your home decreases to less than your current loan balance, creditors may be able to modify the loan to reduce the balance of the loan to equal the current value of the property. In Chapter 13 bankruptcy, a second mortgage can be eliminated altogether, which is referred to as “stripping” the lien. The effect of stripping the second mortgage is that the debt will be treated as a general unsecured claim and discharged discharged along with your other general unsecured debts.
As a practical matter, in order to qualify to have your second mortgage stripped, the home must be worth less than your primary mortgage. Since there would be insufficient funds to pay off the primary lender in the first-lien position, there will be zero funds available to pay the second mortgage lender and their junior-position lien. Note, this option of stripping is only available if the second lien if fully unsecured, meaning there are no funds that the second mortgage lender will receive from the sale of the home. If the second mortgage lender will receive funds from the sales proceeds, they are considered to be “under secured” and the court will deny the motion to value the second mortgage at zero.
This process can completely turn a person’s finances around. Consider a person that has a $500,000 primary mortgage with a monthly payment of $4,000.00 and a $100,000 second mortgage with a monthly payment of $600.00. If the value of the home is less than the $500,000 primary mortgage, this person could file for Chapter 13, motion the Court to “strip” the second mortgage, and if successful, the second mortgage would no longer be secured to the home and the debtor would no longer be responsible to pay the monthly $600.00 to the second mortgage. In addition, by “stripping” that second mortgage, the debtor now just gained an extra $100,000 of equity in their home by completing this in the Chapter 13.
Utilizing the equity in your home and taking on a second mortgage can offer a homeowner many benefits. However, it is important to understand your obligations and risks involved if you find yourself in a situation where you no longer can make your payments. Fortunately, there are multiple options that exist to help you keep your home. If you find yourself in a difficult circumstance, our attorneys at Modesto Bankruptcy Attorneys have the experience to evaluate your matter and provide you with the best option to keep your home and potentially eliminate your second mortgage.
We help clients in the following areas: Modesto, Stockton, Turlock, Ceres, Empire, Escalon, Hughson, Lathrop, Linden, Manteca, Oakdale, Patterson, Ripon, Riverbank, Salida, Tracy, Waterford.
