Guide to Second Mortgages
While home prices have fallen over the last few months, it is still considered a minor retracement from the recent run. Many home owners that have purchased in the last few years have built up a decent amount of equity in their existing home. With the rise in interest rates, many owners are not looking to break out of their existing mortgages. Another popular option to refinancing is a second mortgage.
What is a second mortgage?
A second mortgage is additional financing on your existing property which already has a mortgage. This mortgage will be second in priority over the existing mortgage. The most common type of second mortgages is a Home Equity Line of Credit or HELOC. You can also get a Home equity loan
Difference between a Home Equity Loan versus Home Equity Line of Credit
A home equity loan gives you one-time lump sum payment while a home equity line of credit provides you the ability to access funds as you need them. You will only be charged interest on the funds you use from the HELOC.
Why do you need a second mortgage?
Here are the most common reasons for a second mortgage:
It can be used for financing or buying a second home or a second property such as an investment property.
It can be used for consolidating debt, especially high-interest debt such as credit cards.
It can be used for large purchases such as home renovations
How much can I afford on a second mortgage?
The lender will use debt service ratios to determine how much debt you can hold based on your income. The Canadian Mortgage and Housing Corporation have the following guidelines:
Gross Debt Service should be at or under 35%. Gross Debt Service is calculated as your housing costs (including mortgage payments, utilities, property taxes and condo fees) divided by your pre-tax household income.
Total Debt Service should be at or under 42%. Total Debt Service is calculated as housing costs (defined above) plus any other debts (including car payments and loan payments) divided by your pre-tax household income
The lender will also be looking at the equity you have built up in your home. Depending on the lender, you may be able to borrow up to 80% of your home. The lender will likely hire a valuator to determine the value of your home.
Using the second mortgage to buy a second property
A second mortgage can be used in the down payment for a second property. It is important to distinguish whether the second property is a second home, such as a vacation home or an investment property.
Using the second mortgage for purchasing a second home
If you are looking to get a down payment on a vacation home with a second mortgage, you will need the ability to cover the current costs of your existing home and the vacation home. The costs include housing and debt costs listed above. The minimum down payment required for your vacation home would be as follows:
5% of purchase price for a property with purchase price less than $500,000
5% of the first $500,000 of the purchase price and 10% of the purchase price above $500,000 for a property between $500,000 and $999,999
20% of purchase price for a property above $1,000,000
For any property with a down payment below 20% of the purchase price, you must buy mortgage default insurance.
Using the second mortgage to buy an investment property
You can use your second mortgage towards the down payment on an investment property and grow your real estate portfolio. It is important to find a lender that will consider the rental income on the investment property as part of the debt service ratios. As a note, some lenders will not consider 100% of the rental property in calculating the debt service ratio.
An important benefit to using the second mortgage for the down payment is the ability to deduct the interest from your taxes. The second mortgage would be considered debt for the purposes of investment. The Canada Revenue Agency has allowed the interest on this type of debt to be deductible from your taxable income.
Using a second mortgage to buy a second home and rent out the first
You can also use the second mortgage as a down payment for another home and then rent out the first. It's important to note that the down payment required to buy a home can be less than 20% (see rules above), whereas if you are buying an investment property, a minimum down payment of 20% is required.
What are the cons of a second mortgage?
One of the major cons of a second mortgage is that the interest rates are higher than the first mortgage. This is because the lender is second in line to the lender on your first mortgage. This means that if you default on your mortgage and the lenders are forced to sell your property, the lender on the first mortgage gets paid first then the lender on the second mortgage is paid.
Some lenders also hefty charge fees on the second mortgage. These fees can be 1% or more of the mortgage.
