Any time you take out a loan that is backed with property as collateral, you take out a mortgage. For most Canadians, their first mortgage is the purchase mortgage they use to buy their first home. In many cases, these loans are amortized over 30-year terms that will require multiple renewals, which means that without an aggressive repayment plan, many homeowners pay their mortgages for most of their working lives.

That first mortgage is the primary lien against the property used as security – in most cases, the property that the loan went to purchase. When the property is sold, if the first mortgage has not already been paid off, the first proceeds from the sale will go to cover that outstanding balance. For example, if you sell your home for $500,000, but your primary mortgage still had $325,000 outstanding, you will receive the difference ($175,000) less any realtor commissions or other fees.

After you’ve been paying on your first mortgage long enough to make a significant dent in the principal (the balance still due), you may decide to take out a second mortgage, so that you can have access to that equity you’ve built up. The second mortgage will come with a higher interest rate than the first because of the elevated risk. Why is there more risk? When you sell the property, the bank or lender holding the second loan must wait for the first mortgage to be paid off before receiving any funds.

Let’s go back to the previous example. You have a house with an appraised value of $500,000. You owe $325,000 on the first mortgage, which leaves you with $175,000 in equity. You take out a second mortgage for $75,000, which leaves $100,000 in equity. So where does the risk come in?

A downturn in the housing market could cause your value to drop to $450,000. Or $420,000. Now your equity has gotten extremely small, because even if the value dips, your balances due do not. Let’s say that you get laid off and start missing mortgage payments – and you must sell in a hurry to avoid foreclosure. If you can’t get someone to give you enough money for the house to leave you with $400,000 after commissions and fees, then that second mortgage holder can be left high and dry. However, if you are able to pay for a second mortgage without going into financial distress, there are many advantages.

Purpose of a Second Mortgage

A second mortgage can fulfill any number of purposes. Here are some of the most popular:

  • Major repairs or improvements on the primary residence
  • Consolidation of other debts carrying higher interest rates
  • Paying for higher education expenses
  • Desire to borrow more money than a cash-out refinance mortgage will permit
  • Buying a second home before your first home sells
  • Funding a down payment on a rental property

Types of Second Mortgagees

There are two primary forms of second mortgages: the home equity loan and the home equity line of credit (HELOC). Whereas a refinance mortgage resets the interest rate of your first mortgage, either of these types of financing adds a second lien to your property.

A home equity loan will seem a lot like your first mortgage. You get a lump sum up front and make payments on it over time. You will owe interest on it, and your early payments will mostly go to satisfying the interest expense, with the later payments covering more of the principal. This is the ideal type of loan if you need a large amount of cash at one time – such as putting in a swimming pool, adding a second floor to the house, or redoing the master bathroom or kitchen. You will want to research the mortgage rates Alberta and other provinces are offering. You’ll find that these rates are a few percentage points above first mortgage rates.

A home equity line of credit (HELOC) acts like a credit card but without the high interest rates that credit cards carry. Once you complete your HELOC application and gain approval, you have access to a certain amount of money. You can access it as frequently as you want and only take out what you need at each time. You only pay interest on the money you take out, and you can take out money again after you have paid it back. This is the better option if you do not know exactly how much money you will need or how long you will need it. If you are thinking about adding a wing to your home or using the money to pay college tuition, you may not know what the other funding sources will be. These rates tend to be variable, which means they change as the prime rate changes. Currently, the rates for HELOCs are pretty close to home equity loan rates.

Differences between First and Second Mortgages

The primary differences between first and second mortgages involve priority and interest rate. When you sell a property with mortgage balances still due, the first mortgage is paid first out of the proceeds – and then the second. Because the second lender has to wait until the first mortgage debt is satisfied, the interest rate on a second mortgage will be higher.

Even if you use sources of private lending Ontario and other provinces offer, these differences will remain true. Some people ask us, “Are private money lenders legal?” The answer is “Yes.” Many people cannot gain approval from a traditional lender because of gaps in their employment history or temporary issues with their credit scores, so the entities that offer the sort of private lending Ontario and other provinces need will provide short-term loans, some of which only require interest payments, while borrowers spruce up their profiles so they can qualify for traditional loans after the private loan terms expire.

Pros and Cons of First vs Second Mortgages

Second mortgages have several benefits for homeowners. Let’s look at a few of them:

  • Access to home equity. If you spend 30 years paying off a mortgage, your house basically becomes a giant savings account. The value of the home is likely to appreciate over time, but the equity you build up turns into money that you cannot use today. If you take out a second purchase mortgage on your home, you are basically funding your own loan – with approval from the bank.
  • Reasonable interest rates. If you look at the mortgage rates Alberta and other Canadian provinces offer, you will find that second mortgages offer some of the best interest rates around. They are higher than first mortgage rates, but they are still significantly lower than credit cards and most personal loans.
  • Flexible options for withdrawing money. Most second mortgages come in one of two types: a home equity loan and a home equity line of credit (HELOC). In the case of a home equity loan, you take out a lump sum and begin paying it back over time. In the case of a HELOC, you gain approval to take out money up to a particular maximum. You only pay interest on the amount you take out instead of having to make larger payments on the entire lump sum.
  • Income tax breaks. If you use your home equity loan or HELOC for repairs or improvements on your primary residence, the interest on that second mortgage can be tax-deductible. You will want to talk to your accountant to check to see if that is true about your individual situation, though.

As with any loan, there are potential disadvantages that you will want to consider before you sign the paperwork. Here are a few of them:

  • Loan size restrictions. Obviously, you can’t take out more money than the amount of equity that you have in the house, and many lenders will cap your loan at a conservative percentage of that remaining equity because of the risk involved in housing market fluctuations.
  • Adding a new payment to the budget. Now, instead of just making one mortgage payment every month, you get to make two. This is definitely something to consider if you are already in a two-income home and find it difficult to pay all of your bills each month. Even if you have plenty of wiggle room in your present budget, don’t take on a new monthly payment that will push you into financial stress.
  • Extensive and costly application. Remember all of the paperwork you had to fill out for your first mortgage? You have a similar stack of forms to complete this time around. Going from application to closing can take a few months, and there are closing costs on the end, just like the first time.
  • Your home is at more risk now. Instead of going back to refinance mortgage terms to take more money out, a second mortgage means that you have two loans that use your home as security. Defaulting on either one of them could lead to foreclosure, so you want to make sure that you can satisfy both obligations.

Amansad Financial represents a wide variety of private lenders – individuals and entities that provide first and second mortgages for borrowers going through unique or difficult circumstances that make it difficult to get approval from traditional lenders.

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