1. For those of you that do not know what a second mortgage is, it is a lien (loan) against a certain percentage of the equity of the home. What the mortgage company does is recognizes that you have a first mortgage on your home and they take the balance of that loan, get an appraisal on the home and say you have this amount of equity in the home. As an example, you have a first mortgage of $125k and the home is worth $200k, this gives you equity of $200k – $125k = $75k. Depending on what mortgage company you go with and what their guidelines are you could take out a second mortgage up to 100% of the value of the home.
2. During the real estate boom some lenders did second mortgages up to 125% of the value of the home because during that time the value of the home would probably go up during the next year by 25% to cover both the first and second mortgage in case of a sale or foreclosure. This would give the home owner plenty of money to do with it what they want to do.
3. Now with all of the mortgage mess going on in the United States many mortgage companies have scaled back doing second mortgages to 90% of the value of the home or have removed them from their product lists all together. The banks and mortgage companies are now seeing these home owners that borrowed up to 100% of the value of their home over the past couple years can’t pay back the loans and are going into foreclosure, or they just cannot sell the home because they owe to much.
4. When the Federal Reserve lowered the prime rate down to 1% in 2003 cheap money was starting to flow everywhere. Second mortgages were starting to become very popular because now people could go out and buy whatever they wanted with a home equity line of credit (HELOC) with their effective interest rate around 3%. The banks borrow the money at 1% from the Federal Reserve and make their 2% profit and give you the interest rate at 3%. This was cheap because now everything you bought with the line of credit was also a tax write off because it was included with your loan. When you did your taxes it was like whatever you bought you almost bought with no interest because of the tax write offs. Most home equity lines of credit had payments that were spread out over 30 years so your monthly payments were extremely low.
5. The gravy train lasted for about 4 more years up until 2006. This is when the Federal Reserve decided that it was time to start raising the prime rate. The prime rate is the rate which the Federal Reserve lends money to banks. The Fed started raising rates .25% every month for 17 consecutive months before stopping at 5.25% in 2006. What thie means to the average home owner who took out a home equity line of credit is that their monthly payment on the HELOC has now gone up 4.25% over a 1.5 years. If you do the math lets say on a $50k home equity line of credit your payment went from $125 a month at 3% to $302 a month at 7.25%. Plus, the payments on a HELOC are interest only for the first ten years of the loan so all of the stuff you bought cheaply you are now paying $302 – $125 = $177 more in interest a month and the balance stays the same if you do not pay more.
6. In comes the fixed rate second mortgage. On a home equity line of credit the interest rate is adjustable (There are a few local banks that lock HELOC rates in, but they are very hard to find and usually have stipulations like you need to have a checking account with them). Now the average American home owner does not want to have to deal with rising interest rates because it looked like there was going to be no end as to how high the prime rate was going to go. Now, the mortgage companies saw a reason to start coming out with more fixed rate second mortgages and sold them to home owners and the selling point is now you know what your payment is going to be like without having to worry about interest rates. Some mortgage companies used this as a scare tactic and it worked because the home owners were already scared. Most people already had a really good first mortgage with a low interest rate so it did not make sense to refinance the first mortgage, so all they did was refinance the home equity line of credit into a fixed rate second mortgage.
7. Many people that took a fixed rate second mortgage liked the idea that their payment was not going to move anymore. It is very comforting to know what your mortgage payment is going to be like. Interest rates on fixed second mortgages would depend on how high the total loan to value of your loans equaled. If you still had a lot of equity in your home you would get a lower rate. If you locked in a rate and you owed what your house was worth your mortgage rates were probably about 2% higher. There is a risk factor involved in going up to 100% of the value of the home. There are a variety of fixed second rate mortgages available such as a 10 year, 15 year, 20 year, 25 year, and a 30/15 year. All of the above come with different interest rates and the 10 year would have the best with every one after that probably having .125% more than the one before it. Most homeowners took out a 15 year second mortgage because they knew that they were going to pay it down (HA!). The payments were not high on it but for most people that rolled in credit card debt it did save them money initially, but many just rolled the bills right back up after doing the second mortgage. What most people should have done is find a mortgage company that does the 30/15 loan. This loan was unique in that your payment was put on a 30 year amortization schedule with a 15 year baloon payment. What this means is that you will not have the whole balance of the second mortgage paid off in 15 years (probably half of it will be) but during that time if you wanted to pay more you can. The way to get around having to pay the baloon payment would be to refinance the loan before the 15 years. This gave you a lower monthly payment than the 15 year loan and gave you more flexibility with your monthly cash flow. As an example on $50k a 15 year fixed second mortgage at 7.5% is $463 a month and the 30/15 loan at 7.75% of $50k is $358 a month. This puts $463 – $358 = $105 back in your pocket to invest or even put on top of your mortgage payment.
8. Now, home owners feel great because they have no more worries about mortgage payments. Now you need to ask yourself, “why did you get the home equity line of credit in the first place?” The reason you got it could have been for a number of reasons. You wanted to roll in some credit card debt, buy a rental property, a boat, a car, tuition, home remodeling, wedding, etc. The main reason you opened it was to have money available in case of an emergency. With a fixed second rate mortgage, you cannot borrow anymore. Gone are the days where you can write a check from your HELOC or call the bank and have them forward you a check. You cannot borrow anymore. The only way to get more money out would be to refinance the second mortgage again.
9. Let’s say you are okay with the fact that you can’t borrow anymore money (good for you, going old school and saving). You don’t hear anything about the Federal Reserve raising the prime rate any more. This goes on from June 2006 to September 2007. The Fed did nothing. Then in October 2007 the Fed comes out and says we are lowering the prime rate .5%. Great news. That is for the people who kept their HELOC, not good for you because you locked in your interest rate. The people that kept their HELOC will see their payment go down by .5% the very next month and they still have the flexibility to borrow more money (only if you have not maxed it out) if they want. The Federal Reserve comes out the following 3 months and lowers rates by .25% each month. The real kicker comes in December 2007 when the Fed lowers the prime rate by .75%. This is huge. The pattern continues until march 2008 in which the Fed stops lowering the prime rate at 2%. From June 2007 to March 2008 the prime rate went from 5.25% to 2%. If you kept your HELOC opened your payment every month would have dropped and now would be saving 3.25%. using the $50k HELOC balance example at 7.25% (5.25% + the bank’s 2% profit) a monthly payment would be $302 interest only and $50k at 4% (2% + bank’s 2% profit) is $166 interest only, saving you now $302 – $166 = $136 a month in interest. Now the people who took out a fixed rate second mortgage want to get their HELOC back now to save on interest. Sorry, you can’t. With declining values on homes you probably owe more on your house than what its worth. Very few mortgage companies or banks will even lend up to 100% of the value of the home now and many will not go over 90%. Some have put a hold on doing second mortgages or HELOC’s all together until the real estate market bottom’s out. More than likely you are now stuck with what you got.
10. As you can see from the examples above you really need to weigh in all of the factors when getting a second mortgage. It does not matter if it is going to be a home equity line of credit or a fixed rate second mortgage. If you want the flexibility of having cash readily avaialble then keep the HELOC open. It really is not about the rate when you need cash now. If you just want to know that your second mortgage payment is not going anywhere then lock it in. Just do not complain when rates go lower than yours.