The difference between a first and second mortgage is straightforward. A first mortgage is taken out for the purchase of the home, while a second mortgage is taken out on any residual value between the outstanding loan balance and the value of the house.
The two most common uses that most people put a second mortgage to are home improvement and debt elimination. Both of these uses can make good economic sense if handled properly.
If you are improving your home to such an extent that it will substantially increase the value of the home, a second mortgage is probably a worthwhile investment. Certain home improvements are said to be especially helpful in increasing the value of a home, such as an additional bedroom or an upgraded kitchen.
Some home improvements, however, are nothing more than luxuries and will not affect the future value. An in ground pool is an example that is frequently mentioned, since there are many buyers (with young children, for instance) who would not care to have one.
Paying off expensive interest rate debt is probably a better use of lower rate second mortgages, since you will save a lot of money in the long run. Typically the interest rate on credit cards can be 16 to 20% or more, whereas a second mortgage can be obtained at 5-9%, representing a significant overall savings to the homeowner.
But to take out a second mortgage that it not going to give you either of these ends-add value to the home, or save money on consumer debt- is not a good choice.
Since a first mortgage is paid off from the proceeds of the home in case of default, there may not be enough equity in the home to pay the second mortgage, and this is the risk the second mortgage lender takes.
Therefore, second mortgages will have a higher interest rate than first mortgages. The bank granting the second mortgage will have a higher risk that the loan will not be paid, and increased risk is one of the most important determinants of interest rates.
There are closing costs with second mortgages just as there are with first mortgages. Make sure you are fully aware of all of the closing costs you will have to pay for loan, so that you can be sure the total cost of the loan balances the increased value of the home or the savings on the credit cards!
It really pays to shop around for a second mortgage, since the rates can vary widely. You should also shop around for the lowest closing costs. Closing costs for a second mortgage are a proportionately greater expense since the loan is typically for a smaller amount than a first mortgage.
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