While second mortgages have been around for a long time, the concept of borrowing money against your home's equity took hold in the 1980s. As lenders popularized the second mortgage, referring to it as a home equity loan, more and more people took loans out. While second mortgages were once stigmatized, they've evolved in the public eye as a useful financial tool that, like any other, has both pros and cons.
One of the biggest benefits of borrowing against your house is that the interest might be deductible. The Internal Revenue Service doesn't care what you call your home loan, or whether it's a first, second or ninth mortgage -- it lets you deduct your interest as long as you meet a few standards. First, you have to itemize your deductions -- claiming the standard deduction precludes taking an interest deduction. Second, the interest has to be paid on a loan on your first or second home. Third, you can write off the interest on up to $1 million of home purchase debt, which is money that you borrow to buy, build, fix or improve your home and up to an additional $100,000 of home equity debt, which is money that you can borrow for any purpose.
Relatively Low Rates
Borrowing against your home gets you a relatively attractive interest rate. While second mortgage and home equity loan interest rates are usually higher than first mortgage rates since the loan is riskier for the bank, they're still a lot lower than rates on personal loans and credit cards. For instance, as of March 2013, the national average rate on a bank-issued credit card was 11.72 percent, while personal loans cost 11.7 percent. Interest on a home equity line of credit was 5.56 percent.
Leaving Your Mortgage Alone
If you're trying to decide whether to take out a home equity loan or to pull cash out of your house through refinancing, equity loans have one big advantage. When you take out a second, your first loan stays the same. This means that, if you've been paying on your loan for a while, you'll get to keep the benefit of having more of your payment go to principal. For instance, a $200,000 30-year loan at 5.25 percent has a monthly payment of $1,104.41. $875 of the first payment gets allocated to interest, leaving just $229.41 to pay your balance down. After seven years, your interest has gone down by slightly over $100, leaving $329.59 to pay your balance down.
Extended Payment Terms
You can stretch out a home equity loan for a long time. When you're looking to minimize your payments, this can be a good thing. However, the longer your loan stays outstanding, the more interest you pay. Stretching out your home equity loan saves you money every month -- but costs you more over the life of the loan.
Risking Your House
When you take out a home equity loan, you're putting your house at risk. Just as with a regular mortgage, if you don't pay it, the lender could foreclose and take your house. Other types of debt, such as personal loans and credit cards, are unsecured. If you don't pay them, your lender would have to sue you and convince a court to force you to sell your house -- which, depending on your state's homestead laws, might not be possible. As such, home equity loans and second mortgages are usually wise only if you know you'll be able to pay them back.
- The New York Times: Home Equity Frenzy Was a Bank Ad Come True
- IRS: Publication 936 -- Home Mortgage Interest Deduction
- NCUA.gov: Comparison of Average Savings and Loan Rates at Credit Unions (CUs) and Banks
- The Federal Reserve Board: A Consumer's Guide to Mortgage Refinancings
- Consumer Financial Protection Bureau: What Is a Second Mortgage Loan or "Junior-Lien"?
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