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How do second mortgages work in Canada?

by Corben Grant on 03 Jun 2022

One of the biggest benefits of owning a home is the large amount of equity you can build in your property. However, if you want to access this equity, it isn't as easy as withdrawing it from the bank.

Because your equity is tied up in a non-liquid asset—your home—you will need to use some other tools to be able to take advantage of the value you have accumulated. One of the most common ways is to work with a lender to borrow funds and use your existing equity as leverage to make this possible.

One way that you can do this is by using a second mortgage. That's right—even if you haven't paid off your primary mortgage, you can still get another!

Second mortgages are different from standard mortgages and come in a few different formats. There are also many reasons why you may choose to get a second mortgage and some other options you may opt for instead.

Second mortgages can be a great option, but you may be unsure when to consider getting a second mortgage and exactly how the process works. This article will cover everything you need to know about second mortgages to help you access your home equity.

What is a second mortgage?

The first thing to know about a second mortgage is that it is not the same as buying an additional property with a new mortgage. Rather, a second mortgage is a loan taken against the value of the same property for which you have an existing mortgage.

Buying a second home will be pretty similar to any other mortgage, whereas a second mortgage, in this sense, is a very different product. In addition, when buying a second home, your mortgage is put towards actually purchasing the property. When you get a second mortgage against your home equity, you already own the house, so you can put the money to a different use.

Beyond the distinction between a 'second home mortgage' and a 'second mortgage,' there are a few options for mortgage loans that can be considered a second mortgage. While fundamentally, these different options involve acquiring a sum of money against your home equity, a lot else varies between them.

Home Equity Loans

The first category is what is also commonly called a Home Equity Loan. This mortgage works a lot like your first mortgage, giving you a lump sum of money in exchange for regular mortgage payments of interest and principal. A Home Equity Loan is commonly meant by the term 'second mortgage'.

Home Equity Lines of Credit

Another product that may be considered a second mortgage is a Home Equity Line of Credit. Although these are technically considered a form of mortgage borrowing, they are usually seen as their own distinct product.

In contrast to Home Equity Loans, HELOCs can withdraw at will and have more flexible repayment schedules. Rather than having a fixed repayment schedule, you can pay down your HELOC balance at any time.

Private lender second mortgage loan

You may also be able to borrow against your home equity from private lenders, which could be considered another type of second mortgage loan. These may be similar to either a HELOC or Home Equity Loan, as these private mortgage lenders are less regulated and can make their own loan terms.

Because private lenders’ terms vary so greatly, we won’t be covering these as in-depth here. For the purpose of this article, we will primarily be looking at Home equity loans and Home Equity Lines of Credit.

How do second mortgages work?

From a simple overview, second mortgages have common attributes to conventional mortgages: monthly payments, interest rates, term lengths, closing costs, and more. The bank will provide you with some amount of money, and you will pay them back over a set period of time. There are some more specific things you need to know, though.

How much can I borrow?

The amount of money you can borrow on a second mortgage is a maximum of 80% of your home equity, but this does not mean you will be able to get that full amount in all cases.

First of all, you can only leverage against the equity that you actually own. If you own more than 80% of your home, you may be able to borrow the full amount. However, if you only own 50% of your home, for example, you will only be able to borrow a portion of the home's value.

Secondly, that 80% loan-to-value is offered on a combined basis, meaning all loans you take against your home can only equal 80% cumulatively. This means that you wouldn't be able to use a Home Equity Loan and a HELOC that both provide 80% of your home's value, essentially taking 160% of your true equity.

On a HELOC, you can access a line of credit worth up to 65% of your home equity and with a total of 80% of your combined loan to value ratio when added to your first mortgage. For a Home Equity Loan, you may be able to borrow up to 80%.

Keep in mind that you will be paying interest on any money you borrow, and you will need to pay it back eventually. There is no point in borrowing as much money as possible if you don't have a plan for it.

 

The reason this kind of loan is called a second mortgage is that it takes second priority to your first mortgage on the property. This means that although your home and its value are used as collateral to secure the loan, your primary mortgage is still first in line in the event of a default, meaning they can repossess the title and get paid back first. This makes second mortgages a bit riskier to the lender, even though they are secured against the property.

When looking to get a second mortgage, you do not need to stick with the same lender as your first mortgage and are free to borrow from whomever you like. Going with the same lender may be easier to get approved as they already have most of your information, plus you only need to worry about paying one lender at a time. If you go with a new lender, it may take longer to get approved, but you will also be able to shop around for more rates from different lenders.

Third mortgages and beyond

Technically, it is possible to get even more mortgages beyond your second, but this is not always a wise choice.

Often these subsequent mortgages will be required to borrow from an alternative lender as major banks will not be interested in these types of loans.

Additionally, the overall value available to borrow will decrease the more you borrow against your home, making these loans less useful.

Finally, the farther down the hierarchy a mortgage goes, the riskier it is, meaning you may end up paying a lot more in interest.

Who can get a second mortgage?

The first requirement to have a second mortgage is to have a first mortgage. However, this isn't the only requirement.

You should only consider a second mortgage if you have a significant amount of equity in your home. For one, the amount you can borrow won't be enough to make it worthwhile with lower amounts of equity. Furthermore, while you are at the start of your mortgage, it may be worth paying more into your equity first before you cash out equity for other purposes.

You will need to undergo an approval process to get a second mortgage. However, it may be a bit less intensive than your first mortgage. When you get your first mortgage, you only have to put a small percentage down on a larger purchase, so the bank needs to vet their borrowers carefully. With a second loan, you have home equity greater than your borrowing amount, which secures the loan.

Your bank will consider your credit score during the approval process. The good news is that if you have been successfully paying your first mortgage for a while, this will help your credit score a lot.

Why should I get a second mortgage?

The obvious reason to get a second mortgage is to access your home equity as usable funds. But what can you do with those funds?

The great thing is that you can get a second mortgage for any reason you like, as these funds are yours to use as you see fit.

Many people take a second mortgage to renovate or improve their home, others choose to invest the money, and some put it towards a large purchase like a second home or a car. Others may choose to use the funds from a second mortgage to pay down higher-interest debts to consolidate them under lower interest rates. The bank doesn't really care what you do with the money, as long as you can pay them back.

When you are looking to fund a project or large purchase, accessing your home equity can be a great option because you likely have a lot of value you can leverage. Borrowing against your home can help you access large amounts of money quickly and easily, and you may get better rates than if you got money through a personal loan or another source. Plus, there will be fewer restrictions on how you can spend the money.

What is the approval process like?

Applying for a second mortgage is remarkably similar to applying for your first.

You will need first to choose a lender and begin discussing your options with them. They will want to see a range of supporting documentation proving your property ownership, existing mortgage, credit score, employment, and more.

They will also need to do a home appraisal. When you bought your home, your lender probably did an appraisal on the home you were buying. This is similar. They need to know what your home is worth to know the value of the equity you are borrowing against.

You will also need to pass the mortgage stress test, which will now take into account your existing mortgage as part of your debt capacity.

Once approved, you will need to pay a few closing costs, and then you are good to go. If you took out a Home Equity Loan, you might need to wait a few days for the payment to enter your bank account. Otherwise, your bank will instruct you on how to begin borrowing from your HELOC.

How does interest work on a second mortgage?

Second Mortgage Interest Rates

The mortgage rates on second mortgages will vary based on a few conditions. These may include the amount of equity you own and the amount being borrowed, as well as your credit score.

In general, banks see your second mortgage as riskier than your first mortgage. This is because it always takes second place to the first in the event of a default. In addition, the loan is leveraged against your home's market value, which exposes the loan to volatility in the real estate market.

For these reasons, your second mortgage will generally have a higher interest rate than your first mortgage. Though interest rates vary, HELOCs are generally able to access lower mortgage rates than home equity loans.

How interest is paid

When it comes to paying interest, the two options will be quite different. When you take a home equity loan, you get a lump sum of value that you then must pay back in scheduled payments. Each of these payments will include a portion of interest, and so the amount of interest you can expect to pay over the term is essentially fixed (with some variability if you choose a variable rate.) Some home equity loans may work on an interest-only basis for a period of time, after which point you will begin repaying the principal.

With a HELOC, on the other hand, you only need to pay interest on the amount you have actually borrowed. This means you can reduce the interest you pay by simply using the HELOC less or by paying back your HELOC principal sooner.

However, you should know that HELOCs are not like credit cards with grace periods before interest starts accruing on debt. Rather, your interest will begin to accumulate from the moment you borrow from your HELOC.

HELOCs usually always have variable interest rates that follow the bank's own prime rate. On the other hand, Home Equity Loans can have both variable or fixed rates depending on the borrower's preference.

Second Mortgage Terms

When it comes to second mortgages, they tend to be much more of a short-term option than your primary mortgage. Most second mortgages in the form of a home equity loan have short terms ranging from a few months to a couple of years.

On the other hand, HELOCs have extendable terms that can be continued for many years until you decide to close the line of credit or sell your home.

What happens if I default on a Second Mortgage?

Just like your first mortgage, your second mortgage will need to be paid in the event of a default. This is where the concept of being in second comes into play. Your first mortgage will take precedence and have the power of sale on the property.

Any income from that sale will go towards covering what they are owed. Only after this can any remaining value be used to pay off the second mortgage loan. This can lead to a situation where, for whatever reason, the home sells for an amount that can not cover both loans. In this case, your second mortgage lender will be the one to take the loss. This risk of loss is a large part of the larger interest rates for second mortgages.

Home Equity Loan or HELOC: What's better?

When it comes to comparing these two-second mortgage options, there is no definitive winner or loser. Rather, it is going to come down to what you need out of your second mortgage.

A home equity loan is your best option for someone who wants to get as much money as possible as quickly as possible. It will provide you with a lump sum of cash that you can start spending right away. This may be good for you if you want to invest a large amount of money or make a single large purchase.

A HELOC is better if you want the option to borrow from your equity but don't need everything at once. The ability to borrow and pay back at will allows you to be flexible with your spending while also minimizing your interest paid.

It is also a good option if you plan on financing something in installments over time. For example, if you plan to start a renovation project that may take a while, you can buy as you go rather than paying interest on the money you don't even need yet, as would be the case with a home equity loan.

How does a second mortgage compare to a refinance?

Another common way that people choose to borrow from their home equity is with a mortgage refinance.

When you refinance your mortgage, you pay off your previous mortgage with a new one. Because the amount you borrow may be higher than what you owe on your current mortgage, you can cash out some of the loan to use for anything you like.

Both a mortgage refinance and a second mortgage are completely viable ways to borrow your home equity, so choosing which one is better will be a matter of what works best for your own circumstance.

A benefit of refinancing is that you don't need to worry about paying two separate debts. You can cash out money and continue to pay like you were used to. However, things won't be all the same as before, which is one of the downsides of a refinance.

When you refinance, you need to essentially reset your mortgage. This means you will have a new term and potentially new mortgage rates, and you will need to start at the beginning of your amortization period. Also, if you have a closed mortgage, refinance can come with hefty fees for breaking your mortgage contract early.

On the other hand, with a second mortgage, you don't need to touch your first mortgage at all. You can leave it in place, which means keeping the same terms you are used to and avoiding any refinancing fees.

Also, when comparing a refinance against a HELOC, you will gain the same benefits as when comparing a HELOC to a home equity loan, such as flexible borrowing and repayment options.

Is a second mortgage right for me?

Your home equity is a very valuable source of financing, and a second mortgage is a great way to tap into that value. By accessing your home equity with a second mortgage, you can quickly get funding for any number of purchases or projects—and at favourable terms.

Though there are a few options you will have to choose from (home equity lines, home equity loans, refinancing, private loans, and more). This is a good thing, as it allows you to tap into your equity in a way that is most suited to your needs. Knowing the difference between these options will be crucial in making the most of your home equity. If you are interested in getting a second mortgage, consider talking to your lender or a mortgage broker to see what options may be available to you.



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