If you’re burdened with an overwhelming amount of credit card debt and you’re a homeowner, you might be considering taking out a second mortgage to alleviate your financial stress. With interest rates at an all-time low and a steady rise in home values, it may seem like the perfect time to consolidate your credit card debt into your mortgage. But is it the right move for you? What are the potential risks involved?
In this comprehensive guide, we’ll explore the advantages and drawbacks of refinancing consumer debt with a second mortgage. We’ll also delve into alternatives for dealing with high balances on your credit cards if a debt consolidation mortgage isn’t feasible or if the rate is too exorbitant for your liking.
Understanding Second Mortgages
A second mortgage, also known as a home equity loan, is a new mortgage loan that is secured by the equity in your home after accounting for your primary mortgage and theoretical selling costs. The funds from a second mortgage can be utilized to pay off debt, finance a renovation, or for any other purpose you deem fit.
Do note that a second mortgage is not the same as a home equity line of credit (HELOC). While a second mortgage has fixed monthly payments and an amortization period, a HELOC is an open, revolving credit limit that allows you to borrow and repay money as per your needs and comes with monthly minimum payments.
Eligibility for a Second Mortgage
The amount of home equity you possess determines how much you can borrow with a second mortgage. Equity is calculated by deducting real estate commissions, outstanding mortgage principal, penalties, legal fees, and property taxes from your home’s current market value.
Traditional lenders usually offer up to 80% of your home equity on a first mortgage. A second mortgage can allow you to access up to 90% of your home value for a debt consolidation mortgage. However, since a second mortgage is a high ratio mortgage and riskier for the lender, it typically carries a higher interest rate than a first mortgage.
Risks of a Second Mortgage
When you take a second mortgage, your lender will place a lien on your property. If you fail to maintain your monthly payments, the lender could potentially foreclose on your home. In such a scenario, your second mortgage lender will only receive payment after the first mortgage, property taxes, and legal costs have been covered.
One of the substantial risks of home mortgage debt consolidation is the conversion of unsecured debt into secured debt. Unsecured debts like credit cards, lines of credit, payday loans, and income taxes are debts that the lender cannot recover if you default, other than by suing you in court. On the other hand, a second mortgage is secured with your home as collateral. If you fail to pay your mortgage, the lender can claim your property.
Financial Implications of a Home Equity Loan
The primary reason why people opt for a second mortgage is to pay off credit card debt and other bills. However, the question remains: will a second mortgage truly alleviate your debt or simply prolong the inevitable?
When lenders assess an application for a second mortgage, they consider the following:
- You must have sufficient available equity to cover the amount you wish to borrow.
- You need a strong employment history and an acceptable debt-to-income ratio, generally below 43%, including any new financing.
- You need a credit score in the low to mid- 600’s, depending on the lender.
However, the main consideration should be whether taking a second mortgage is a wise decision for you, not just whether the bank is willing to lend you the money.
Key Considerations
Before you decide to consolidate your debt with a second mortgage, you should take the following factors into account:
Sufficiency of Borrowed Amount
If you don’t have enough equity in your home to repay all your outstanding credit card debt, then this might not be the right solution for you. It usually doesn’t make sense to consolidate some but not all your debts. If you can’t manage everything with a second mortgage, you should explore other debt relief solutions.
Affordability
You should evaluate whether taking out a second mortgage will solve your cash flow problems. A second mortgage does consolidate several credit card and bill payments into one extra mortgage payment. However, it usually carries a higher interest rate than a first mortgage, which could make it unaffordable in the long run.
Risk of Foreclosure
If you default on your new second mortgage, you could endanger your credit score and potentially risk your home to foreclosure. Converting unsecured credit card debt into a secured second mortgage could result in losing your home through foreclosure or power of sale even if there’s no equity in the home.
Future Plans
A second mortgage can be a risky way to consolidate if it doesn’t align with your long-term financial goals. If interest rates rise, or the housing market crashes, and your home value declines, or you lose your job, your financial situation could worsen.
Interest Rate
Second mortgages typically carry a significantly higher interest rate than your first mortgage. While a first mortgage may have a rate of around 3%, a second mortgage could cost up to 10%.
Alternatives to a Second Mortgage
If you don’t qualify for a second mortgage, or the interest rate is too high, you might want to consider an interest-free consumer proposal. A consumer proposal allows you to stay in your house and negotiate a repayment plan with your creditors to pay back what you owe over up to five years.
This strategy may sound counter-intuitive when you have equity in your home. However, if you’re struggling with substantial unsecured debt, it may be a safer option than taking on a risky second mortgage. It’s always a good idea to discuss your options with a mortgage broker or a Licensed Insolvency Trustee to ensure you make the best decision for your financial future.
