Second mortgage

The thought of having a second mortgage against their property makes most borrowers feel sick. Some feel that second mortgages are the first step towards financial disaster, a sure sign of insolvency.

While home buyers and home owners might feel better with only one mortgage, the number of outstanding mortgages does not determine financial insecurity. Instead, what matters is the total amount of money borrowed compared to its fair market value, or, put another way, how much equity they have in the property.

Let's say - someone's equity in his house is $30,000, based on a fair market value of $150,000, whether one mortgage for $120,000, two mortgages for $100,000 and $20,000, two mortgages for $80,000 and $40,000, or three mortgages for $60,000, $40,000 and $20,000 are registered against the title to the property. In all these cases, 80% of the value pie is held by other people, while owner's ownership share is the remaining 20%. The first $120,000 is held by one or more people other than someone, while he owns the last $30,000 in equity.

The rate payable on the second mortgage will depend on borrower's equity, too. If the first and second mortgages do not exceed 75% of the appraised value, the second mortgage really is as safe as a first mortgage (except for the fact that a prior first mortgage exists), and the rate charged should reflect this. If borrower's equity is less than 25%, the second mortgage will bear a much higher rate of interest to reflect that additional risk, the exact rate depending on the security, the covenant, and the lender.

Second mortgages are riskier for lenders, too, but that's not our concern. Yet second mortgages can be an effective way to reduce the high interest cost associated with residential mortgages, especially if money is needed by existing home owners with a specific purpose in mind.

Someone booked a $100,000, 8% first mortgage two years ago, with monthly payments of $763.21. Now he owes $97,218.57. He would like to borrow another $27,781.43 (bringing their total debt to $125,000) for home improvements and renovations by arranging a home equity loan. Two options are open to him:

• Arrange a new $125,000 first mortgage, or
• Arrange a new $27,781.43 second mortgage

The rates quoted for the two options are 8% for the new first mortgage, and 11% for the second mortgage. But before automatically assuming the new first mortgage route is cheaper, borrowers must ask a critical question. Will the early repayment of the old first mortgage lead to a sizeable prepayment penalty? If they stay with the same lender, no prepayment penalty should be incurred, since more funds are being advanced to them on the same property. But that ties their hands considerably, since it prevents borrowers from shifting their business elsewhere, to benefit from another lender's terms and rates.

If a new $125,000 mortgage was arranged at 8%, amortized over 23 years (since two years on the original mortgage have now passed), the additional $27,781.43 borrowed would cost borrowers $32,412.66, based on a $218.10 increase in the monthly payment from $763.21 to $981.31.

Even though most second mortgages are calculated monthly and their interest rates generally are at least 3% higher than first mortgages, this still could be the cheaper route for borrowers to follow. If the additional $27,781.43 is financed by a second mortgage at 11% calculated monthly (11.2552% calculated semiannually) and amortized over 10 years, the total interest cost will be $18,141.20, a savings of over $14,000, despite the higher interest rate.

True, the amortization for the second mortgage is only 10 years, not 23 years. True again that the payment for the $27,781.43 second mortgage is $382.69, which is quite a bit higher than the additional monthly cost for financing that amount through a larger first mortgage. But both those differences reflect reality. Most second mortgages are arranged by existing home owners for a special reason. Because of this extra expense, most borrowers want to retire it as quickly as possible. A shorter amortization accomplishes this, making a second mortgage an attractive alternative. So the second mortgage option allows borrowers to reduce their indebtedness faster, and at an overall cost that's lower than the cost of refinancing their first mortgage.

There is another reason borrowers with low-rate first mortgages should consider the second mortgage route: to avoid losing the benefit of that first mortgage, if the first mortgage is refinanced. The annual interest rate of the first and second mortgages combined could be substantially lower than current rates.

Someone has a $100,000 first mortgage at 8% and need a further $25,000. Current first mortgage rates are about 10%, while the rate quoted him for the second mortgage is 13%. To calculate the approximate average interest rate for a first and second mortgage, take the fraction that each loan is of the total, multiply it by the interest rate for that loan and add the results together. For example:

First mortgage: $100,000 / $125,000 x 8% = 6.4%

Second mortgage: $25,000 / $125,000 x 13% = 2.6%

Total average interest rate: 9%. So he should take the 13% second mortgage and average out the interest rate, rather than book a new 10% first mortgage and lose that 8% below market rate.

When a new second mortgage is arranged, it should mature at the same time as the existing first mortgage. This gives borrowers maximum flexibility, since both mortgages can be refinanced together or separately, whichever is cheaper. If this is not possible, the second mortgage should contain a postponement clause, allowing the existing first mortgage to be renewed or replaced without any difficulty. Otherwise, the second lender could prevent borrower from doing anything with his first mortgage unless the second lender is also paid off at that time or is paid a bonus for remaining second in priority.

Second mortgages also serve a useful purpose when a home buyer has just under 25% equity. Mortgage payment insurance is charged when the loan is high-ratio -over 75% of the appraised value -on the whole mortgage, not just the part exceeding 75%. If borrower's shortfall in equity is small and his covenant is strong, he should consider arranging a conventional first mortgage for just 75% of the purchase price. That eliminates the insurance fee, since that mortgage is no longer high-ratio.

Appearances can be deceiving, especially with second mortgages. Before saying no to it, compare the total cost of one high-ratio mortgage requiring an insurance premium with the cost of a conventional first mortgage and a small second mortgage. The "right" choice is the one that will save you the most money.

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