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December 2005 |
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That Second Mortgage Could Be Twice the Trouble 
America could very well be in the midst of a debt crisis. We are in debt to foreigners. We have a trade deficit. And, with bankruptcies increasing every year recently, and exploding housing prices, we are very much in debt to each other. There comes a time when we've got to tell ourselves, "Enough is enough."As Debt Matters often mentions, debt is not necessarily a bad thing. In fact, handled correctly, it's a fundamental tool for building wealth. But handled recklessly, it can lead to financial ruin. And a lot of people are getting into trouble with "second mortgages" or home equity lines of credit, which are attractive because they are usually lower interest rates and the interest that you do pay is often tax deductible. So, what's the problem? First of all, let's recognize what a second mortgage is. Years ago you bought a home and as you've been paying the mortgage, and if the home has appreciated, you've been building equity. In other words, your principal is going down, the home's value is going up, and you are indebted on less and less of the home. Well, a second mortgage basically undoes all or some of that equity building. You could be turning back the clock to the day you bought your home or worse. If you paid $100,000 for your home and paid the mortgage down to $80,000 and the home meanwhile appreciated to $110,000, you'd have $30,000 in home equity. But if you borrow that money back from a bank, you now have a combined mortgage of $110,000 — which is $10,000 more than the day you bought your home! That's going backward. And remember those low interest rates? The reason the bank can provide those low rates is because the loan is secured by your home. But that means anything but security for you. If you default on the loan (fail to make payment) the bank can foreclose on your house, sell it and recover some of their money. So, a second mortgage strips away an important line of defense in our financial lives — home equity. So who should tap their home equity? Home equity lines make lots of sense at times — especially if the mortgage has been paid down considerably. Going back to the $100,000 example, if only $30,000 remains on the mortgage, borrowing back $30,000 still leaves at least $40,000 in home equity. Also, because the individual has paid down the loan, they've proven they can handle the mortgage payments. In other words, it's a much safer play, so why not take advantage of the low interest and deductibility? Then the question becomes what are you using the money for? One particular good usage is making an addition to your home. This way, you are reinvesting the money you borrow back into your home. Your mortgage goes back up some, but your home is now more valuable. Also, people do use second mortgages as a last line of defense. If a job loss or medical emergency has run up credit card debt, many people borrow a lump sum, pay off their debts and make one payment each month to the bank. It's up to the individual as to whether they are comfortable with the added risk to their home in exchange for the lower interest rates and single payment. |
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