Homeowners do NOT use a second mortgage
An intuitive conclusion about the tight inventory of homes for sale is that the amount of equity homeowners have in their homes has been increasing for several years. Long-term ownership, along with rapid appreciation in prices, means that homeowners have ten and hundreds of thousands of dollars of accumulated wealth in the form of equity in their home. But you might want to keep this wealth safe.
According to historical data from the Federal Reserve, in the past, significant home equity led homeowners to take out a second mortgage. This was especially true from 1988 to 1992 and again from 2000 to 2005. There was another small increase in second mortgages from 2005 to 2008. However, since banks have demonstrated how easy it is to foreclose homes and withdraw that value Mortgages are dropping seriously. Home equity loans have been declining steadily since 2009. The number of US homeowners paying both a primary and secondary mortgage or a home equity loan has fallen by about half since 2009, according to Census Bureau data.
If current owners aren’t selling so they can move into a bigger, better home, should they use the existing equity to fund improvements, additions and other financial reasons? There are options as well as pros and cons to this question.
Should you take out a second mortgage?
There are two basic types of second mortgage. One is a lump sum loan secured by the equity you already own in your home. Typically, a second mortgage goes up to 80 percent of the equity you own.
The second type of loan is a Home Equity Line of Credit (HELOC). Just like the title suggests, you can access credit as needed by writing a check or using a credit card rather than looking at it as a lump sum.
One of the main reasons that second mortgages have declined is that the interest tax deduction severely limits how the money can be used. Interest is not tax deductible if the money is used to repay student loans, to consolidate consumer loans, and interest is not tax deductible if used as a down payment for vacation homes, or for any other use that is not directly related to the house by which the loan is secured.
“The 2017 Tax Cuts and Jobs Act, enacted on December 22, suspends the deduction of interest paid on home equity loans and lines of credit from 2018 to 2026, unless they are used to buy, build, or significantly improve the taxpayer’s house that secures a loan. “ – IRS, IR-2018-32, February 21, 2018
There are other important considerations other than the tax deduction. One important is the Annual Percentage Rate (APR). This is the total amount of interest you will pay on a loan for one year. The APR includes any fees you might have to pay, plus the interest rate. While personal loans generally carry a higher interest rate, the APR for a second mortgage can be higher due to all of the other fees. Taking out a second mortgage is pretty much the same as taking out a first mortgage. Tons of fees and costs like appraisals go into the cost of getting the loan. You can usually include all charges in the loan amount. However, this increases the loan amount, which also increases the amount of interest you pay each month. Take a close look at the true cost of money before assuming that the slightly lower interest rate on a second mortgage saves you money compared to a personal loan.
And then there’s this locking issue. This second mortgage is secured by the equity in your home. If for some reason you are late on payments, the bank can and will foreclose on your house. In contrast, most personal loans are unsecured (the reason for a higher interest rate). If you fall behind on payments on most personal loans, your credit rating will suffer, but no one is likely to take your home away from you. And here’s a boost, your home equity is still working in your favor for a personal loan. Your fairness is probably your greatest asset. When this value is used to calculate your total assets and net worth, you will likely get a lower interest rate on a personal loan.
Deciding between a second mortgage or a personal loan is more complicated, but those are the big considerations for most people.
Homeowners don’t even use a second mortgage for renovations
The move away from second mortgages for personal loans is undeniable. 9 in 10 people (90%) use personal funds to finance home renovations, according to a TD Bank survey. This matches data from the Federal Reserve showing a continued decline in the number of home equity loans taken out.
The TD Bank survey found that almost all homeowners planning home improvements find sources of money other than second mortgages. People who plan to upgrade the kitchen, add another bathroom, or just redo the landscaping say the money will come from:
- 98.51% will use their personal savings.
- 6.32% will take out a personal loan.
- 1.05% will use bonuses and commissions.
- 1.05% will borrow from other sources such as family and friends.
- 0.0% will finance with a home equity loan.
You will not be able to amortize the interest on these other loan sources. But on the other hand, your home will not be at risk of foreclosure. The personal loan approval process is also much faster and requires less time and energy.
Certainly you have ideas and experiences with second mortgages or personal loans. Please share by leaving a comment.
Additionally, our weekly Ask Brian column welcomes questions from readers of all levels of experience with residential real estate. Please send your questions, inquiries, or story ideas to [email protected]
Author Biography: Brian Kline has been investing in real estate for over 35 years and has been writing about real estate investing for 12 years. He also draws on more than 30 years of business experience, including 12 years as a director at Boeing Aircraft Company. Brian currently lives in Lake Cushman, Washington. A vacation destination, close to a national and the Pacific Ocean.