Bricks and mortar are attractive collateral for money lenders. If you have equity in your home one way to get a loan for investment purposes is to offer your property as collateral. This is called a second mortgage. Second mortgages are essentially a loan upon a loan or, to use some jargon, a loan that is subordinate to the first mortgage. What that means is that if you default on your loan, the first mortgage will get paid out first, and only then will the second mortgage be paid out. Second mortgages are more of a risk to lenders so they tend to have higher interest rates. Functionally speaking, a home equity loan (where you use the equity in your home to fund further investments), is the same as a second mortgage.
The major lenders are busy educating people about the value of home equity loans, so most people are aware of the many advantages of these types of loans, but they also pose many risks.
Debt consolidation
There are many reasons why people take out an additional loan using a mortgaged property as collateral. The increasing amount of household debt in Australia is one of the most common reasons. Second mortgages can provide an easy avenue for debt consolidation, and are typically have much lower interest rates than the average credit card. However, most second mortgages will be about one to four percent higher than most first home loans. That’s because the priority for payment still rests with the first mortgage, so a higher interest rate acts is one way to mitigate the higher risk for the lender.
Leveraging your equity
People also take out second mortgages, however, to fund further investments. If your home loan was for say $350,000 in 2002, by 2007 your property may be worth $440,000. You may wish to either “release” the equity in your property ($90,000) to use as a deposit to fund the purchase of another property – or to buy shares or other investments. Or you may wish to borrow, for example, $150,000 against the increasing value of your property for a similar purpose. In this way you are leveraging your asset to build further wealth – assuming you make wise choices about how you invest the additional cash.
That said, a second mortgage can also be useful if a property you have owned for a while needs renovations. One way strategy may be to take out a construction loan to finance the renovations then have the property revalued and refinanced once the renovation is completed. The valuation will take into account its new renovated value and the new loan will allow you to consolidate your interest payments. This is quite a common way to fund renovations and leverage equity.
Retirement
People also take out second mortgages to experience a lifestyle benefit from the increasing value of their homes. As property prices have increased significantly, many people now have a great deal of equity sitting in their homes. Taking the example of Robert Smith, who bought his house in Hunters Hill in 1985 for $300,000, it’s current value of $750,000 could provide him with a large amount of equity for other things, such as a holiday, a boat, new car or gifts for his family. It could also form the basis of an allocated pension to fund Robert’s retirement, but he would be smart to look into a different type of loan for that purpose, called a reverse mortgage. (There are more and more products on the market aimed at retirees in this situation. Some loans are interest free. It is worth shopping around for the latest products).
A second mortgage is not to be confused with refinancing. Usually people pay out the existing loan and take out a mortgage for a similar amount with a provider who offers a better deal. This can save thousands of dollars in interest payments and drastically reduce the life of a loan. A word of warning, however: check the fees associated with exiting and entering the loans. It may not be worth your while if they are too hefty.
The biggest risk – overextending
Second mortgages are not without significant risks. If your investments fail you may even lose your property and still have a massive debt. If you spend the money unwisely on consumer goods you may find yourself in a compromised situation later in life when your earning capacity is zero. Bankruptcy is another possibility. However, a smart investor will be able to leverage their equity and use the additional funds to provide a new stream of income for themselves and to get a hold over further assets, that should also increase in value over time. Cashflow is an essential aspect of this kind of strategy. Your accountant and a financial planner are the best people to advise you on this.
The Mortgage and Finance Association of Australia (MFAA) has a lot of useful information about the various loan types available, as well as debt consolidation and home loan “health checks”. There is also good information about how to work out when it might be the right time to take out a second mortgage.
