Going Into Debt to Get Out of Debt: The Dangers of Second Mortgages

Under the right circumstances, home equity can be your own personal golden goose. If you’ve lived in your home for some time and benefited from a rising local economy or made extra payments to reduce your mortgage quickly, you’ve created equity you can access.

From renovating that out-dated kitchen, paying for college, starting your own business, or paying down a mountain of debt, home equity may seem like easy money, but beware, misappropriating your homes equity could land you in deep financial straits. If you are considering taking out a 2nd mortgage on your home-sweet-home, there are several things you should be aware of.

When used to pay off your current unsecured consumer debts, a second mortgage can help spread your debt over a much longer time period (i.e., amortize) while lowering your overall monthly debt payments today. The disadvantage is that you will be paying over a longer period of time and paying out much more than what was originally borrowed since much of your initial payments go directly to interest.

Barring any personal concerns over inflated interest rates and overflowing big-bank purses, the following outlines some of the issues you should think about before getting a second mortgage on their home.

Re-Payment – If you’ve secured a second mortgage through a high ratio lender, you will be paying a much higher interest rate compared to your primary mortgage rate. Your budget needs to be able to support the new second mortgage payments.

The actual monthly payment may not seem too high (depending on the amount borrowed), but nonetheless, you’re funnelling much more money towards interest than principle in this endeavour, not to mention incurring inflated fees and penalties associated with ‘risk premiums’ that many secondary mortgage lenders charge. Be sure to screen the lender you plan to work with to ensure they have a reputable track record.

Market downturn – To make matters worse, a slow real estate market can lower your property’s appraised value, causing highly leveraged homeowners to end up owing more on their home than it’s worth (i.e., sometimes termed ‘under-water’ or ‘upside-down’). This was common for many homeowners in the US following the subprime market crash.

By the end of 2009, almost 25% of US mortgage holders were underwater, owing more on their mortgage than what their property was valued, with almost 50% of those mortgages worth 125% of the property’s value. Clearly, Canada made it through the recent global economic freefall remarkably unscathed, and Canadian homeowners fared much better than their US counterparts.

This, however, does not mean that we’re immune from future global economic concussions which directly affect housing prices. Pending any future negative economic situations, the stability of your local market moving forward is one area needing consideration before pulling the trigger on that new loan.

Loan to Value – Second mortgage lenders take bigger risks than primary bank lenders. To offset the risk of default due to a high loan-to-value (LTV) ratio or an overextended borrower they charge higher rates of return on their loans.  Typically the lower the LTV, the lower the interest rates as the risk is lowered.

Often it is just a numbers game where they expect a certain number of borrowers will default per loans made, but their overall return on all investments exceeds the losses they may incur on any defaults. In addition, a high LTV ratio leaves a homeowner little wiggle room when market conditions cause local property values to drop and puts their finances upside-down.

Mortgages secured by the Canadian Mortgage and Housing Corporation (CMHC) carry less risk for the lender since the loan will include mortgage insurance, but also carry significant insurance fees for the borrower. Currently CMHC restricts LTV to 95% of the property value, and a conservative homeowner may want to limit their LTV to some percentage below that level.

Other aspects to consider include the amortization schedule, job stability or income loss, spikes in mortgage rates over the term of your loan, or possibly a myriad of other variables that combine to make this a decision worth careful thought. Planning to upgrade your kitchen, buy a new car or take a dream vacation is definitely within reach if you are willing to cash in on unused home equity, but prudent homeowners are advised to consider both the positive and negative aspects of this decision before cashing in their home equity.

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