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Second Mortgages – How Do They Work?

A couple in the kitchen of their home cutting oranges.

Given today’s relatively low mortgage rates, obtaining a second mortgage can be a viable option for Canadians in need of extra funds. It’s one of the options available to homeowners who want to borrow against the equity they’ve built up in their home.

A second mortgage, however, is not the same as your primary mortgage (or even a home equity line of credit) and what follows will help you learn more about the basics of second mortgages, their benefits, possible drawbacks, and how to qualify.

What is a second mortgage?

A second mortgage is an additional loan that allows homeowners to borrow money against the equity in their home, without refinancing their current mortgage. Equity is the difference between the appraised value of the home and the outstanding balance owed on the first mortgage.

How much can be borrowed?

Let’s say your home is valued at $125,000 and you still owe $40,000 on your mortgage. The equity you’ve built up would total $85,000. However, this $85,000 in equity is not the amount you could get when applying for a second mortgage. There are limits to how much you can borrow. For example, you can borrow no more than 80% of your home’s appraised value, less what’s left on your mortgage. In our example then, the maximum second mortgage loan you could apply for would equal $60,000.

It’s also important to remember that a second mortgage does not replace your first mortgage. You’re expected to make payments to both mortgage loans as scheduled, and these payments can’t exceed your maximum allowable Total Debt Service (TDS) ratio. Should you default on either of the two loans, you risk losing your home.

The pros and cons of a second mortgage

There are a variety of reasons why a homeowner might seek out a second mortgage. Some do it to consolidate high interest debt into one lower interest rate monthly payment. The money can also be used to undertake home improvements to increase your home’s value, help pay for a child’s college or university tuition, to assist a family member with their down payment for a home, or for emergency expenses.

Whatever the reason for needing a second mortgage, the primary benefit is access to a relatively large sum of money when other options don’t make sense (i.e. credit cards).

There are also some drawbacks to keep in mind. For example, the interest rate on a second mortgage is typically higher than the rates available for a principal mortgage. This is because second mortgages are riskier for lenders to underwrite. To compensate for that additional risk they charge slightly higher interest rates.

You may also have additional closing costs to pay. This can include a home appraisal, legal fees, title search and title insurance, which is often needed to secure a second mortgage.

How to qualify for a second mortgage

What’s needed to qualify for a second mortgage will depend on your credit score, the amount of equity you’ve built up in your home, your employment history, and income.

Your Total Debt Service (TDS) ratio will also be factored. This is the percentage of your annual gross income needed to cover all your debts, including your mortgages, credit cards, vehicle payments and the like. Each lender will have different requirements, and some will be stricter than others. However, if the lender with whom you have your primary mortgage is unable to offer you a second mortgage, you’ll have to shop around.