First off, what is a second mortgage and what does it mean to have a 2nd mortgage? Simply put, a 2nd mortgage is a loan registered behind an existing mortgage loan in chronological sequence. For example, if you currently have a mortgage on your property and you are seeking additional funds without refinancing the existing mortgage, you are doing so by way of securing the funds in the second position behind the existing mortgagee (Lender).
The “Mortgage Position” to a lender is very important as it determines (in part) the risk exposure that they are putting themselves in when advancing funds. The higher the position a lender holds on a mortgage, the lower their risk exposure will be in relation to the risk of successive mortgagees registered to the property. In order to explain why, consider the following scenario:
There is a property worth 500k with an existing mortgage of 350k (70% Loan to Value) and a borrower obtains a 2nd mortgage of 100k (90% Loan to value). In this example, the borrower has a total loan of 450k on their property. Now consider a situation whereby the borrower defaults on their mortgage payments and after trying to remedy the missed payments with no success, the 1st mortgagee exercises their right to a power of sale. The lender is now taking possession of the home in order to sell the property to reclaim the balance of the outstanding principle amount of the loan (plus any miscellaneous fees outlined in the original mortgage agreement with that mortgagee). Since the home is now under power of sale, the listing price of the home is usually placed slightly under market value to trigger a quick sale. In addition to this, there are a lot of fees that are incurred by the lender including legal fees, realtor fees, etc, that are ultimately reclaimed during the disbursements of funds after the sale of the property. The repayment of the 2nd mortgagee is not addressed until the 1st mortgagee has fully settled their loan (plus fees incurred by taking power of sale and any other applicable fees outlined in the original mortgage agreement). As you can probably tell, the 2nd mortgagee is in a riskier position to reclaim their principle loan because their mortgage is 2nd to the interests of the first. Once the first has been taken care of, the remainder of the funds will be used to pay off the 2nd mortgagee. Sometimes, depending of the loan to value of the original loan (90% in this case), the 2nd mortgagee may potentially stand to take a loss on their investment if there are insufficient funds left over.
This example also explains why 2nd mortgages have higher interest rates than 1st mortgages. Since the mortgage position that is held is secondary and the risk exposure is higher, 2nd mortgage lenders will often justify the risk by charging higher interest rates on the loan itself. Generally speaking, you will notice that 2nd mortgagees are usually held privately or made by private investors rather than banks due to the greater amount of risk involved in being in 2nd position. This does not mean that banks will not do 2nd mortgages. In fact, if the loan to value is fairly low and the applicant meets their banking guidelines then a low interest 2nd mortgage (usually a line of credit) can be approved.
Benefits of a 2nd mortgage:
- These lenders are quick to review applications and ultimately fund approved deals. In addition to this, lenders usually only ask for a handful of supporting documents to review as opposed to banks.
- Interest on a 2nd mortgagee, although higher, are often less than most credit cards and personal loans and are a great way to consolidate debts.
- Lenders are usually not interested with why you need the money, as much as your ability to afford the interest payment on a monthly basis. Since these lenders usually weigh their decision to approve the loan based on the property and available equity, they are comfortable advancing the funds despite the purpose of the loan.
- 2nd mortgages are usually short term open mortgages of up to 1 or 2 years with less prepayment penalties then 1st mortgages (usually because the size of 2nd mortgages are almost always less than 1st mortgages)
- If you are locked in a 1st mortgage with major penalties and cannot justify the fees to refinance for more money , 2nd mortgagee is a great option to access the equity from your home
- If your current financial circumstances have negatively changed and your credit standing has dropped, it may be better to leave your 1st mortgage untouched because your qualifying interest rate on a new 1st mortgage may be significantly higher.
- In addition to this, 2nd mortgage funds can be used to repair credit for future refinancing by paying off unsecured credit card and personal debt
Things to look out for:
- Interest rates on 2nd mortgages are almost always higher than 1st mortgages
- 2nd mortgages are hardly ever amortized, so the monthly payments are based on interest only payments
- Be prepared for fees such as lender, brokerage, and legal which are usually taken from the mortgage proceeds
- You should consider an repayment strategy before obtaining the loan
- It is important to note that 2nd mortgages are usually meant to be short term loans and holding on to a 2nd mortgage for long periods at a time can be costly.
i. For example, if you are borrowing 20k for 1 year then you must consider how you intend to repay the loan in one year. The 2 most common options that borrowers face when it comes to second mortgages is to either:
- Renew or refinancing just their 2nd mortgage or
- Refinancing their 1st mortgage to pay off the 2nd mortgage.
It is very important to understand all aspects of a second mortgage before you decide to apply for the loan. Only after you understand this, will you be truly capable of making an informed decision on whether a 2nd mortgage is right for you. For any additional information or questions you may have, please give us a call at 905.455.5005 or visit our website at www.cmsmortgages.ca