The largest investment that many Canadians will make is the purchase of a home. Because the vast majority of home buyers don’t have the cash on hand to make the entire purchase, they have to take out a mortgage – a loan that covers the gap between the purchasers’ down payment and the agreed purchase price of the home. Many mortgages amortize over periods between 15 and 30 years, making it a commitment that will last through a considerable part of most Canadians’ professional careers.
If you look at a 25-year or 30-year amortization schedule for a mortgage, you will notice that, for the first year or so, purchasers aren’t making much of a dent in the principal, or the amount due on the loan. Instead, the vast majority of the early payments go to paying the interest expense of the loan. With each payment, the ratio shifts toward paying more of the principal and less of the interest, but over the term, this shift is quite small each month. This means that building equity in the home takes a significant amount of time when property values remain flat.
After more time goes by, though, homeowners build significant equity in their homes. Equity is the difference between the amount they owe on the home and the home’s current value. In most cases, residential property values also increase over time, which allows equity to build in that way as well. When equity builds over time, it becomes a sort of savings account, building as the property appreciates in value and as the homeowner makes payments. As the equity in a home builds, then second mortgages become possible.
Purpose of a Second Mortgage
People take out second mortgages for a number of reasons. When the equity off the purchase mortgage reaches a certain level, the available amount of money can become attractive. In neighboring United States, for example, as of Q2 2023, the averaging homeowner with a mortgage had almost $290,000 in equity. That represented an increase of almost 50% of the average before the COVID-19 pandemic ($182,000).
The types of mortgages rates Alberta and other provinces offer can make second liens a popular choice. The best reason to consider this sort of funding is an improvement on the home that will boost its eventual market value. The most common ways to do this include renovations, remodeling projects, and expansions to the home. The homeowner actually uses home equity to create more equity as time goes by.
There are other reasons to consider adding a lien to your purchase mortgage, of course. Some of the most popular include:
- Debt consolidation to pay off revolving debt that has higher interest rates
- Facilitating the purchase of a vacation home or investment property
- Paying for higher education expenses
- Covering unexpected medical expenses
- Handling other unforeseen financial emergencies
You might also have heard of a refinance mortgage as a possible option. In some cases, you can take out a refinance mortgage that allows you to take some cash out of the equity, basically hitting the “RESET” button on some of your mortgage. This is different from a second mortgage because you still just have one mortgage payment each month. You use the new loan to pay off the old one and then start making payments on the new one. When you take cash out as part of the process, your principal will increase by the amount of cash you take out. Refinance mortgages take longer to close, so if you are facing emergency expenses, a second mortgage might be the better option for you. However, if you also want to adjust the term and/or interest rate of your existing mortgage, refinancing may be a better idea than a second mortgage.
Types of Second Mortgages
The two most popular types of second mortgages are home equity loans and home equity lines of credit, or HELOCs. The mortgage rates Alberta and other provinces offer on both of these products will generally be much lower than the rates that people have to pay on personal loans and revolving debt in the form of credit cards.
A home equity loan is a lump sum that a borrower takes out against the equity of their home. For example, if a home is worth $750,000 and the balance due on the mortgage is $250,000, then the homeowner has $500,000 in equity. Because of the risk that home values can drop, in most cases, the homeowner would have to leave between $75,000 and $150,000 in equity, meaning that the highest home equity loan available would be between $350,000 and $425,000. As soon as that second mortgage closes, the borrower receives the funding – and a new amortization schedule for this new lien on the property.
A home equity line of credit (HELOC) allows more flexibility for the borrower. The dollar amounts would be similar, but if the borrower in the above example received authorization for a HELOC of $400,000, the interest and payments would not begin until the borrower accessed some (or all) of the available amount. The homeowner can tap the line of credit for smaller amounts as time goes by and would only pay principal and interest on the amount that was actually borrowed.
Differences between First and Second Mortgages
A second mortgage will have a higher interest rate than the first mortgage in most cases, unless the first mortgage was taken out when interest rates were significantly higher – but in that case, the recommended step would be a refinance to take advantage of the lower rates.
Why will the second mortgage have a higher interest rate? It represents a higher risk to the lender. If something happens financially and you can no longer make your mortgage payments, and you have to sell the property, the balance of the first mortgage has to be satisfied completely first, and then the second mortgage is paid. This could become a problem in the case of a short sale or a foreclosure sale, in which case the proceeds from the sale might not be enough to cover both loans, especially if home values have dropped.
Pros and Cons of First vs Second Mortgages
While a second mortgage can help solve a lot of problems, particularly in terms of emergency financing or paying for improvements to the property, it can also cause some issues if borrowers aren’t careful.
For starters, a second mortgage adds a new payment to your budget. So, if you’ve planned ahead and have room in your budget, then this type of loan can make a lot of sense. If you are taking out a second mortgage to buy a vacation home or a dream cruise, it’s worth asking if that second property is really worth putting your home at potential risk.
Sometimes getting a second mortgage (or a refinance mortgage) from a traditional lender isn’t possible. Sometimes borrowers have gone through personal struggles such as a divorce or extended illness. In other cases, they’ve had financial setbacks such as an extended lay-off before finding work again. In cases like this, there is access to the sort of private lending Ontario and other provinces have available. When credit scores and borrowing profiles don’t quite meet the specifications of banks and credit unions but potential borrowers have the means to make payments comfortably within their budgets, then private lending is something to consider.
Private lenders are individuals or business entities looking to invest in the mortgage market. Their interest rates will be higher than what borrowers will find with traditional lenders because the borrower credit profiles represent higher degrees of risk.
One question that we get at Amansad Financial is, “Are private money lenders legal?” Absolutely. We have a network of individuals and entities that are willing to provide the type of private lending Ontario borrowers – and borrowers from all over Canada – need to make their financial visions into reality.
Private loans generally have terms of no longer than a year, giving borrowers the time they need to clean up their credit profiles so that a bank or credit union can approve renewal at the end of that term. In some cases, the private lending providers will allow borrowers to make interest-only payments and collect the entire principal back at the end of the term. This can free up a significant amount of money in your budget to settle other debts and get your credit score where it needs to be for banks or credit unions to extend you additional funding.
When looking for a 1st or 2nd Mortgage, exploring options with your Bank or Local Credit Union should be your first stop. However, sometimes the Red Tape involved with Institutional Lenders prevents a positive outcome. Amansad Financial Services is prepared to explore your Private Lending Options provided the requests makes sense and a good exit strategy is in place. Contact Us if a Private 1st or 2nd Mortgage may be needed. We have relationships with a variety of Mortgage Investment Entities and Individuals looking to be a short-term bank replacement.