Tina McManus' Blog
You’ve been paying off your mortgage for 10 years, building equity while making careful financial decisions to ensure that you’re on track to pay off your mortgage. So, all of those payments are essentially money in the bank for you, right?
Not quite. The equity you’ve built toward is home isn’t really accessible until you either fully pay off the home, sell your home and use your equity toward a down payment, or use it to take out a second mortgage.
In today’s article, we’re going to be talking about second mortgages--what they are, when to use them, and when you should seek out other options. Hopefully, by the end, you’ll be able to make a more informed decision.
What is a second mortgage?
A second mortgage is somewhat deceptively named. The process of taking out a second mortgage revolves around using your equity as collateral toward a second loan. That loan amount doesn’t have to be used toward a home, however. It can be spent pretty much at the discretion of the homeowner, as long as you stay within the spending limits of the loan terms.
Why take out a second mortgage?
Homeowners typically take out a second mortgage when an expense is tossed their way, whether foreseen or unforeseen. It could be a costly house or vehicle repair, a child’s education, or any other large expense that you might not have been aptly prepared for.
Types of second mortgages
There are two main types of second mortgages that homeowners qualify for. First is a standard home equity loan. You receive a fixed-rate loan that usually paid off over a loan term of 15 or 30 years.
The other type of second mortgage is a home equity line of credit (HELOC, for short). A HELOC is similar to a credit card in that you are approved for a certain amount but don’t need to spend the full amount.
Risks of home equity lines of credit
This type of loan is ideal for expenses that you maybe don’t know the full cost of. However, there is an inherent risk in taking on an expense that might go over the credit limit of your HELOC.
Just like with credit cards, interest rates vary. However, the interest rate is linked to something called a “benchmark rate.” When interest rates for the benchmark increase, so do your HELOC rates.
Aside from the variable interest rates, HELOCs can also prove to be difficult to manage for people who are already in credit card debt. So, it’s only recommended that you take out a HELOC if you are sure that you can stay on top of your monthly payments and are in good standing with other credit lenders.
Risks of home equity loans
Standard home equity loans aren’t without their own risks. For one, you’re putting your house on the line when you take out a second mortgage. So, before taking out a home equity loan on a new expense, be sure that you can manage that expense or you could risk losing your home.
Having a second mortgage can also make it difficult to refinance your home loan, which could cost you in the long run if it would otherwise pay off to refinance.
Benefits of second mortgages
Second mortgages do have their time and place. Home equity loans, for example, can help you achieve a lower interest rate than a typical loan if you have a great deal of equity built in your home. This could make the most financial sense over the long term.
Similarly, a HELOC might be a better option than a credit card for homeowners who don’t have a credit score high enough to land them a good interest rate.
Your 401K is a great resource of investing for retirement. Many people use their 401k’s as a part of their overall investment strategies, pulling money out of it when it’s needed. When you’re ready to buy a house, you may think that pulling money out of your 401k for a down payment is a good idea. But think again.
Although you should always speak with a financial professional about your money matters, the bottom line is that is probably not the best idea to use your 401k to supply money for a downpayment on a home.
First, your 401k funds are pre-tax dollars. That means that you haven’t paid any taxes on these funds. Your employer will often match the amount of money that you put into your 401k, as an incentive to help you save money for your future. You need to keep your 401k for a certain amount of time before any funds in the 401k become available to you without having to pay any kind of penalty. If you decide to take on the penalty, you can often face a cut to your employer’s match programs as well. This is why you must make this decision wisely.
Anyone under the age of 59.5 pays a penalty of 10 percent to take the money out of the fund. In addition, you’ll now need to pay taxes on this money, because it becomes a part of your adjusted gross income.
If you are looking to invest in a property, there may be other options for you rather than pulling money out of your 401k. While some plans allow you to borrow money from it. However, if your only option to get money to invest in a property is to pull money from your retirement account, it may not be the best time to invest in property for you.
Keep It Separate
If you’re younger (say in your 30’s or 40’s) your best option is to have a completely separate account that is used to save for a downpayment and other expenses that you’ll incur when you buy a home. In this sense you aren’t spreading yourself too thin as far as investments go. You should compartmentalize your money. Buying a home is a large investment in itself. Home equity can also be a good source of a nest egg in later years when you need it. However, even if a property will be an income property, it’s never smart to take from one investment account to provide for another unless you’re shifting your focus. You don’t want to reach retirement, only to see that your funds have been depleted and you can’t retire as expected.
When considering becoming a homeowner, one of the decisions you can make that will be beneficial to you is to deposit a down payment. However, the question is how do save up that hefty down payment?
One of the biggest roadblocks for prospective home buyers is securing a down payment. Fortunately, though, technology seems to be playing a huge factor in shrinking the burden of down payment. The whole saving process has become quite a bit less rigorous.
Below is a list of how you can overcome the down payment hurdle and ensure you have enough money when it’s time for you to buy.
Save A Fixed Amount Every Month
Saving a fixed amount is the simplest and most convenient way to save money. Open a savings account and discipline yourself to pay in a certain sum into the account every month. Discipline yourself not to use the money for any other purpose aside for your down payment.
Save a lot more than you spend, review your expenses and cut down on items that are not necessary. Whatever money generated as a result of this should be added to your down payment account.
Skip Vacations for A Year
I know going for a vacation during the year is something you are looking forward to and you have it all planned out. However, if you are looking to save up enough money for your down payment, then you should consider scrapping out vacation until you have enough money for your down payment.
Reduce Your Debt
Having a credit card with a high interest rate can limit your ability to save. Pay off your interest debt starting with the highest; after that, you can close off that card while you proceed to pay off the next.
Borrow from Your Retirement Plan
You can ask human resources or your payroll officer if it’s possible to borrow against your savings to buy a home. Many profit sharing setups make provisions for employees to loan a certain amount from their retirement plan to become a homeowner.
Borrow from A Relative
When it comes to getting a home of your own, most family members and relatives would be willing to help; they can grant you loans without interest, gifts and other non-monetary items that will help you in your down payment quest.
Get Another Source of Income
Getting a second job would mean you would probably be working round the clock, but in the long run, it would pay off. Getting another job means another source of income and more money to save into your down payment accounting.
Saving for a down payment, getting your debt eliminated, or wanting to pay for a car in cash; these are all worthwhile financial goals. Although you may think these are hefty expectations that are unattainable, there are ways to achieve them with planning. Creating financial health is achievable with a willingness to see money for what it is: a tool. When you learn how to manage and direct your money, you will be able to put together plans toward the things you want to accomplish.
Evaluate, Eliminate, and Create to Win Financially
Looking at your current income and living expenses can give you an idea of what it will take for you to carve out a path to your destination. You may find your income needs to grow to gain ground. There are a plethora of ways to increase your income. You may need to get a second, or third, job. Develop one of your hobbies into a side business. Sell some of your unused stuff. Think of what services people are looking for and what they will pay to have these done for them and fill that gap. Maybe your path to increasing your income is to go to school for more education. Many professions pay more for added certifications or degrees. Make sure the cost of the additional education will bring enough increase to your future income to be worth your time and the expense.
A Little Bit of Planning Goes a Long Way
In addition to increasing your income, you will want to look at the possibility of decreasing your expenses. Write out a budget, look to see what is a fixed expense and a variable expense. Ask the tough questions. Are the payments a necessity or convenience? The things that are not necessarily adding value to your goals, can you do without them? You will have to change the way you approach your lifestyle. Think about making your coffee at home instead of grabbing it on the go - pack that afternoon snack along with your lunch. Make a weekly menu, then a complete shopping list, and take one trip to the grocery store instead of running in on your way home from work when you are hungry. This change will take some time management skills. Prepping your food for the week ahead during the time you would typically choose to do other things, takes discipline. Keep your goals in mind when tempted to order that pizza and rent that movie.
This week write down two financial goals and how you can achieve them. Your mortgage broker can give you an idea of where you need to be to qualify for a loan, so get some free advice to help you shape your goals.