What is a Second Mortgage in Canada? – How it Works

You’ve finally realized the dream of buying your house and put a few years of equity into it – congratulations! While getting into your house might be wonderful, the actual process of finding the perfect house can be downright miserable.  Most people who buy a house in Canada need to make adjustments especially when they end up with something a bit different from their original ideas. These houses often need a bit of work to meet the expectation of the buyer.

This is only one situation where a second mortgage might be a great option for you, but let’s get into the second mortgage and explain some of the finer points so you’re prepared to sign on the dotted line.

What is a Second Mortgage?

When you take out the mortgage to buy your home from another party, this is a primary mortgage.  Taking out another loan on the same property is known as a second mortgage.  It may also be known as a home equity loan, but that can also refer to a few different types of loans in addition to your primary mortgage.

There are a couple of things you need to know before hopping on your bank’s website to start filling out the forms.

How Does Second Mortgage Work?

If you’ve been dutifully submitting payments towards your primary mortgage every month, then you’ve more than likely built up equity in your home.  You may be able to use that equity to qualify for a second mortgage.

You can actually increase the equity in your house in two ways: either you pay down your mortgage or the value of your home increases.

Once you start asking lenders about a second mortgage, they will generally look at four areas that are broadly similar to those for a primary mortgage:

–          The equity in your home – The more equity you have, lenders will see you as a good bet

–          Steady source of income – just like with your first mortgage, lenders want to make sure you will be able to pay back your loan.

–          Credit score – this will have an effect on the interest rate for your second mortgage.

–          The house itself – lenders want to find out if they will have a good chance of selling your house if you are unable to pay your loans, so they will send a professional home appraisal company to provide the current value of the house.

Once you qualify, you will be able to dive further into the process and see what options are open to you.

Is There Only One Type?

Nope!  Technically, we’re talking about the second mortgage, but there are a few different types of home equity loans to consider.

A second mortgage is specifically a loan taken out against the equity you have built up on your home.

A refinanced mortgage is not exactly a second loan.  With this option, you are taking out a new primary mortgage to benefit from lower interest rates and using it to pay off the original primary mortgage.

A Home Equity Line of Credit (HELOC) is essentially a very complicated credit card.  You can set up a HELOC if your lender allows it with a credit limit and borrow as much as you want up to that limit.  You will need to pay it back over time or at specific intervals as dictated by your lender.

How Much Money Can I Get?

For a second mortgage, the limit you can borrow is up to 80% of the appraised value of your home (remember, you can benefit from increased home value also) minus the balance of your mortgage.

You might be asking, “Why 80%?”  This is linked to Private Mortgage Insurance (PMI) that you pay if you don’t have a 20% down payment or until you reach 20% equity in your house.  In other words, you must maintain 20% equity in your house in order to qualify for a second mortgage.

Let’s provide an example and say that your appraised home value is $500,000 and you have total equity of $200,000.  That means that 80% of your home value is $400,000, and you still owe $300,000.  You could qualify for a second mortgage of up to $100,000.  Think of the kitchen you could build with that!

Don’t get ahead of yourself though because a second mortgage can come with several unknown downsides.  First, the interest rates for a second mortgage could actually be higher than your primary mortgage.  This is because, in the unhappy event you can’t pay back your loans and the house is foreclosed upon, the primary mortgage takes priority on repayment after your house is sold off.

You may also need to be prepared for several additional fees such as appraisal fees, title search fees, title insurance fees, and legal fees, so it almost turns into a whole other closing process. 

It may be in your best interests to have all of these figures ready to go as well as a clear plan for the money.  You’ll want to be sure that either your home value will benefit from the second mortgage, or you are able to use it for some other benefit.

On that topic, let’s dig into what you can use your second mortgage for.

What Can I Use a Second Mortage For?

Once you’ve built up a sizable bit of equity, you essentially have a big pile of money available to re-invest in something you may otherwise not qualify for or would incur a higher interest rate.  No, we do not recommend you take out a second mortgage to invest in the stock market.

However, the most common reason for taking out a second mortgage is to pay for home improvements.  Kitchens mentioned above are popular, though any home improvement project can be the goal, from inside your home to the landscaping around it.

Improving your home helps increase the value of the home, though be sure to do some research so that you’re not over-upgrading your house.  If you turn a $500,000 house into $750,000, but most of the homes in your neighborhood are only selling for $500,000, then you may not be able to sell for what you want in order to recoup the second mortgage amount.

You can also use your second mortgage to pay for your kids’ college in lieu of college loans that would almost certainly come with higher interest rates.

Another interesting option is for those with too much credit card debt, which carries a very high average interest rate, sometimes up to 30%!  You don’t need to take out the whole amount you qualify for, but the rate for a second mortgage might be a good idea if you can qualify for a lower interest rate than the credit cards.  Use it to pay off the credit cards and allow yourself some time to pay off the debt.

Summary

A second mortgage is a loan you take out after you’ve built up some equity in your home, which would have to be at least 20% of the home value.  It can be an invaluable tool to help you either achieve a goal otherwise outside of your budget or simply hide away as an emergency fund. 

Make sure you have a clear plan in mind for not only the money but also the plan for paying back the loan.  Many foreclosures occur because the borrowers took out second mortgages without clear plans in place regarding paying back. 

That being said, once you have your plan, you can dive into the really fun part of either improving your home, sending kids to college, or just giving you a way to reorganize your finances and live with better peace of mind.

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