With every mortgage payment you make, you own a little bit more of your home. Even if you are still many years away from fully repaying your mortgage, you are building equity. Many people don't realize that they can borrow against some of that equity by taking out an additional mortgage on their home. This is called a second mortgage.
When you need a large sum of money - say to consolidate debts or do a renovation, a second mortgage can be a cost-effective way of leveraging your investment in your home.
How do Second Mortgages Work?
Your first mortgage, the one you took out when you purchased the home, is called a primary mortgage. The primary mortgage lender would have the right to full repayment of the mortgage amount if you were to break the mortgage or default on the payments. A second mortgage lender is next in line, to be repaid with the remainder of the proceeds of selling the home. For this reason, second mortgages are usually based on the amount of equity held in the home.
Canadian mortgage rules allow homeowners to get a second mortgage for up to 80% of their equity. For example, if your home is worth $1 million and your remaining mortgage balance is $500,000, you have $500,000 of equity. For a second mortgage, the most you could borrow would be 80% of that, or $400,000. Interest rates for second mortgages are often higher than primary mortgages reflecting the additional risk for the lender in being second in line for repayment.
How Can the Money Be Used?
Unlike your first mortgage, in which the money you borrow can only be used towards purchasing the home, you can use the proceeds of a second mortgage for just about anything. One of the most common reasons to take out a second mortgage is to consolidate other higher interest debts, including credit cards, car loans, and student loans. Second mortgages offer lower interest rates than other types of consumer loans and a longer amortization to allow you to make manageable payments.
Second mortgages are also often used to fund major renovation projects which add value to the home, such as adding an extension or a second storey. Still, other reasons you might consider a second mortgage includes paying tuition for yourself or a child, starting a business or helping kids with a down payment on their own home.
Is a HELOC Different from a Second Mortgage?
A home equity line of credit (HELOC) is a type of second mortgage that has become popular among homeowners. A traditional second mortgage involves the lender giving you the full amount of the loan. You then make regular payments according to the amortization schedule and repayment terms. The loan is discharged when the principal and interest are fully repaid. A home equity line of credit offers more flexibility in the repayment schedule, and more importantly, any money repaid is available to use again if you need it.
In a nutshell, a HELOC is a revolving credit amount that you can use as much or as little of as needed. Interest is calculated on the outstanding balance each month, and a small amount of the principal must be repaid. Otherwise, you are free to use and pay the balance as needed.
Taking out a second mortgage or opting for a HELOC depends on what you intend to do with the money and how you intend to repay it. One option is not better than the other. As always, before making any decisions, we recommend speaking with a mortgage broker who can answer your questions and help you decide on the best path forward. A broker can find the right second mortgage or HELOC lender and the best interest rate available.