If you have a lot of credit card debt and own a home, you may be thinking of getting a second mortgage to pay off debt. Interest rates are low, and home values are rising. Is now the right time to consolidate credit card debt into your mortgage, and what are the risks?
In today’s article, I’ll explain the pros and cons of refinancing consumer debt with a second mortgage. I’ll also discuss options to deal with high balances on your credit cards if you don’t qualify for a debt consolidation mortgage or the rate is just too high.
Table of Contents
What is a second mortgage and how does it work?
A second mortgage (also called a home equity loan) is a new mortgage loan secured by any equity in your home after deducting your primary mortgage and theoretical selling costs. Proceeds from a second mortgage can be used to pay off debt, finance a renovation or for whatever purpose you’d like to use the money.
A second mortgage is just one mortgage solution to help you consolidate credit card debt.
A second mortgage is not the same as a home equity line of credit (HELOC). A second mortgage has a fixed monthly payment and amortization period, similar to how your first mortgage works. A home equity line of credit is an open, revolving credit limit that allows you to borrow and repay as you need money and comes with monthly minimum payments.
Refinancing is when you break the terms of your current mortgage and get a new mortgage. You can add to the principal of your first mortgage when remortgaging if you want to pay off other debts with the extra money. However, it’s not always wise to refinance your first mortgage if your primary lender will charge a pre-payment penalty or they are not willing to lend you more money at the same low rate.
How much can I get approved for a second mortgage?
The amount of home equity you have determines how much you can borrow with a second mortgage. Equity is what your house is worth if you were to sell it minus real estate commissions, outstanding mortgage principal, penalties, legal fees, and property taxes.
Traditional lenders will loan up to 80% of your home equity on a first mortgage. A second mortgage can allow you to access up to 90% of your home value for a debt consolidation mortgage. A second mortgage is a high ratio mortgage making it riskier to the lender, which means that second mortgages carry higher interest rates than a first mortgage. However, more than equity room, affordability should be your primary consideration when determining how much to borrow on a second mortgage.
If your home’s value has risen, you may have substantial equity built up in your home that you can use to consolidate debt including high-interest credit cards, payday loans, and other unsecured debt. I’ll discuss more on the pros and cons of using that strategy for paying off debt below.
What happens if you don’t pay your second mortgage?
When you take out a second mortgage, your lender will place a lien on your property. If you fail to make your monthly payments, there is a risk that your lender can foreclose on your home. In the event of foreclosure, your second mortgage lender will only be paid out after the first mortgage, property taxes and legal costs.
One of the most significant risks of home mortgage debt consolidation is converting unsecured debt into secured debt.
Unsecured debts like credit cards, lines of credit, payday loans, and income taxes are debts where the lender has no recourse if you don’t pay except to sue you in court, obtain a judgment order and maybe a garnishment order.
A second mortgage is secured with collateral, your home. If you don’t pay your mortgage, your mortgage lender can take your house. If you don’t pay your credit card debt, your credit card lender can take you to court and sue you, but they would need special permission from the court to enforce a judgement by registering the judgement against your house, which is why a credit card lender typically gets a court order to garnishee your wages, as compared to a mortgage lender whose primary recourse is to take your house.
Is consolidating debt with a home equity loan good or bad financially?
The number one reason people take out a second mortgage is to pay off credit card debt and other bills. The question is, will a second mortgage help you clear up those debts or add further strain to your finances? For some people consolidating debts with their home equity works, and for others, it simply prolongs the inevitable.
When lenders are considering an application for a second mortgage, they have specific qualification guidelines:
- You must have sufficient available equity to cover the amount you are asking to borrow
- You will need a solid employment history and acceptable debt-to-income ratio, generally below 43%, including any new financing.
- You will need a credit score in the low to mid- 600’s depending on the lender. Your credit rating will affect not only whether you receive a second mortgage but will also influence your interest rate.
However, the point of this post is to help you determine if it’s wise for you to get a second mortgage, not whether the bank will agree to lend you more money.
Here are five factors you should consider before you commit yourself to consolidating debt with a second mortgage.
Can you borrow enough to pay off all your debts?
As a starting point, if you don’t have sufficient equity in your home to repay all your outstanding credit card debt (or whatever debts you want to put in your consolidation loan), then this is a non-starter. It probably does not make sense to consolidate some but not all your debts. If you can’t deal with everything with a refinanced second mortgage, you should look to other debt relief solutions to solve your debt problems.
Can you afford the extra mortgage payments?
Second, you should evaluate whether taking out a second mortgage will solve your cash flow problems.
One advantage of a second mortgage is that you convert several credit cards and bill payments into one extra mortgage payment. However, second mortgages charge a higher interest rate than a first mortgage. If you have bad credit, this rate can be very high. I have seen people take on a second and even third mortgage with a rate of 29% or more. If your mortgage rate is high because you are a high credit risk, there may not be enough savings to make a long-term difference in your ability to get out of debt.
Will you risk foreclosure?
If you can’t afford to keep up with the payments over the long run, you could end up defaulting on your new second mortgage. This will only make your situation worse, further dragging down your credit score and potentially risking your home to foreclosure.
Keep in mind a second mortgage loan is secured by your property, and if you stop making your payments, you can lose your home since your debt is no longer unsecured. Converting unsecured credit card debt into a secured second mortgage entitles your second-mortgage lender to take your house through foreclosure or power of sale, even if there is no equity in the home.
What are your future plans?
A second mortgage can be a risky way to consolidate if it doesn’t help your long-term financial goals.
If interest rates rise, or the housing market crashes, and your home value declines, or you lose your job, your financial situation may become even worse.
If you need to sell your house, you will have to pay off the second mortgage. You should factor in real estate commissions and moving costs as you may have less net equity than you think, depending on the time involved.
Is the interest rate too high?
By their very nature, second mortgages have a significantly higher interest rate than your first mortgage. While a first mortgage may carry a rate of, say, 3%, a second mortgage from a more traditional lender might cost up to 10%.
If a traditional lender turns you down for a second mortgage, they are doing so because they believe the risk of lending you more money is too high. They are concerned about your ability to make your future mortgage payments.
When a traditional lender denies you credit, you may be tempted to turn to alternative lenders. This means borrowing against the equity in your home but at an even higher interest rate. Second tier private mortgage lenders or B-lenders may be willing to approve your mortgage application; however, the interest rate on high-risk second mortgages can be extremely expensive. Sub-prime mortgage lenders can charge second mortgage rates between 10% and 29%.
Your primary mortgage lender will often give you a reason why you are being denied a debt consolidation loan through your mortgage. It could be because you do not have enough equity to pay off your debt or because they are not convinced your income will be enough to make the payments, even if you have the equity.
Rather than approaching a high-cost secondary lender, you may want to consider an interest-free consumer proposal. I’ll explain when to consider that option to use your home equity to deal with unsecured debt at the end of this article.
When not to get a second mortgage debt consolidation loan
There are four situations when you should not get a second mortgage to pay off debt:
- You have some equity in your house, but you can’t borrow enough to pay off all unsecured debts
- You don’t have the income or credit to qualify for a second mortgage
- The interest rate is so high you won’t be able to afford the monthly mortgage payment
- You are using a second mortgage to cover monthly expenses because your budget is not balanced, and consolidating other debt into a second mortgage won’t solve that.
Although you can get rid of credit card payments and overdue bill payments with a second mortgage, you now have two mortgages to pay.
There are inherent risks with a second mortgage, even if you qualify and can afford the payment today. Stress test your decision based on what may happen in the future. Rising interest rates will make your mortgage payment much higher. If housing prices fall, and you have borrowed 80% to 90% of your current home value, you may find yourself with negative equity in your home and large monthly mortgage payments.
When to consider a consumer proposal
It may sound counter-intuitive to talk with a Licensed Insolvency Trustee about your debt when you have equity in your home. However, if you are struggling with significant unsecured debt, a consumer proposal may be a better option than taking on a risky second mortgage.
A consumer proposal allows you to stay in your house and make a repayment plan with your creditors to pay back what you owe over up to five years.
There’s no interest on consumer proposal payments, unlike a second mortgage that could carry a higher interest rate, which means all your payments go towards paying down the principal of your debt.
How much of a debt settlement you may be able to offer, if any, depends on your income and home equity. It is possible to file a 100% consumer proposal instead of creating another mortgage to pay.
If you have high credit card balances and own a home with positive equity, I generally recommend talking with a mortgage broker first to see how expensive a second mortgage may be. If you don’t qualify or can’t afford the payments, it’s time to speak with a Licensed Insolvency Trustee about the benefits of filing a consumer proposal instead.
Very good post. A couple of additional thoughts. (1) Often a second mortgage lender will not be worried about a low credit score if the covenant is otherwise good. (2) Second mortgages can be an excellent way to pay off a consumer proposal and accelerate the recovery process by several years.
As an example, suppose a debtor still owes $15,000 in her Hoyes Michalos consumer proposal, and is paying $300 per month towards it. A second mortgage could be arranged to pay off the whole amount and the new monthly payment would be comfortably under $200.
Couple this repayment with a proper credit score rebuild, and in a few short years her credit report will be singing like an angel.