A primary mortgage lender advances money to a borrower, who uses the funds to finance the purchase of a home. A mortgage is a secured loan, since the home acts as a collateral for the borrowed sum. The homeowner is expected to make principal and interest payments on a regular basis. If the borrower defaults on the mortgage payments, the lender has the authority to seize the home. Sometimes, the homeowner may have a few financial commitments that may compel him/her to procure another loan. In this scenario, the homeowner may choose to avail a second mortgage loan, by pledging the same home as collateral. A second mortgage lender, unlike a primary lender, has a subordinate claim on the house. In other words, if the borrower defaults on the primary and the secondary mortgage loan, repossessing the home becomes the primary lender’s prerogative. A traditional second mortgage can be a fixed rate level payment loan or an adjustable rate loan. Again, a second mortgage can be a home equity loan (HEL) or a home equity line of credit (HELOC).
HEL and HELOC
A homeowner avails a home equity loan by borrowing against the built up home equity. Built up home equity is the difference between the market value of the home and the mortgage payments made on the primary mortgage loan. If the balance is positive, the homeowner is eligible to use the equity on the house for the sake of availing a loan. The rate of interest on the loan is fixed, and the loan is ideal for homeowners who need access to funds for meeting one-time expenses.
Second Mortgage and Home Equity Loan
For a long time, a second mortgage and a home equity loan were synonymous. HEL was ideal for borrowers who needed funds for meeting one-time expenses. However, a number of people felt the need for a system that allowed them to borrow money to meet financial commitments as and when they arose. A loan, that functioned like a credit card by allowing people to borrow against their built up home equity, emerged in the 1980s. Since the borrower used the built up home equity to procure the necessary funds, the credit was a second mortgage. However, it differed from the traditional HEL on account of the following reasons.
The home equity line of credit (HELOC) ensured that the borrower had access to funds, that were sanctioned by the lending institution, on the basis of the built up equity. The borrower could choose to withdraw funds using a check or a credit card, withdrawals not exceeding the amount of money sanctioned by the lending institution. The money that was withdrawn during the draw period which usually lasted for 5 years, had to be repaid at the end of the draw period. The line of credit carried an adjustable rate of interest that fluctuated along with the prime rate. A home equity loan, on the other hand, was a lump sum amount of money, a one-time disbursement. The loan carried a fixed rate of interest and had to be repaid within a period of 5 to 30 years.
It’s evident that the term second mortgage can refer to a home equity line of credit (HELOC) or a home equity loan (HEL). However, a home equity line of credit need not necessarily be a second mortgage. This is because a HELOC may be used for mortgage refinance loans, or it may refer to a line of credit to a homeowner whose first mortgage has been discharged. Refinancing is the process of replacing a secured loan, typically a mortgage loan, with another loan carrying a relatively low rate of interest and having favorable repayment terms. In such cases, HELOC is a primary mortgage.
Refinancing a primary mortgage loan and obtaining a second mortgage are entirely different. While the former provides the borrower the benefit of a reduced interest loan, that replaces the higher interest rate mortgage loan, the latter refers to borrowing a loan in addition to the already existing primary mortgage, using the same property as a collateral.
The above discussion on availing second mortgage vs. home equity loan, may have left the readers confused about the appropriate course of action. It may help to remember that HELs are best for discharging one time expenses, while HELOCs are appropriate for meeting financial commitments that may crop up on a frequent basis. It would behoove the readers to note that while most HELOCs are secondary mortgages, some may be primary.