Let’s say you’ve done your research, you want to consolidate debt, a personal loan isn’t for you, and you are comfortable using the equity in your home to pay off debt. You shop around for rates on a cash out refinance and you choose a lender. Half-way through the application process, the loan officer asks if you’ve considered taking out a second mortgage for $30,000 instead of refinancing your first mortgage so you can cash out $30,000.
Taking out a first mortgage or second mortgage depends on many of the same factors as taking out a first mortgage or personal loan.
#1 Closing costs. The first factor, closing costs, involves comparing the closing costs by doing a new first mortgage vs. the costs associated with getting a second mortgage (Home Equity Line of Credit or fixed rate second mortgage). If you refinance your first mortgage, you are getting a new loan that pays off your current loan and lets you walk away with cash. You pay closing costs on the new loan amount, so any cost that varies based on the loan size (such as title insurance, origination points, recording fees) will be higher the higher the loan amount. With a second mortgage, you pay closing costs just on the amount of the second mortgage.
#2 How far into your current loan you are. The second factor requires that you look at how long you’ve had your loan. If it’s a thirty year fixed and you’re ten+ years into the loan, you are starting to pay more principal with every payment. If you refinance and get a new loan, you start all over again with Month 1 with most of your payment going to interest. Therefore, the newer your loan, the more it might make sense to take out a new first mortgage vs. a second mortgage.
#3 Your ability to pay off the loan. The third factor asks you to honestly assess your ability to pay off the loan. If you think you’ll be able to pay off the $30,000 in three to five years, the second mortgage might make sense.
#4 Mortgage rates. The fourth factor is rate. Second mortgages are almost always higher in rate than first mortgages. Why? Because they are in second position (they get paid off after the first mortgage, in case of default) and thus are riskier for a lender. Second mortgages are either fixed rate loans or Home Equity Lines of Credit (HELOC). If they are a HELOC, they are based on Prime plus a margin. At best, you might find a HELOC that is Prime even (i.e., the margin over Prime is zero). But right now, Prime is at 5.00%, so you can see that a HELOC would be more expensive than a new first mortgage. Fixed rate seconds are similarly high. The rates are in the mid-5s or higher. Either way, the rates are higher than taking out a new first mortgage. However, what you should look at when you compare a first to a second mortgage is what your overall payment would be. Compare a new bigger first mortgage with what your payment would be if you left your current mortgage alone and got a new second mortgage. Chances are the payments might not be that different and if the closing costs on refinancing to a new first are high, you might be better off taking a second mortgage instead.
#5 Loan to value. With a new first mortgage, you can borrow up to 80% of your home’s appraised value. With a HELOC, you can borrow up to 90% or even 95% of your home’s appraised value. Therefore, if you need to take out the maximum amount of equity in your home, you might need to take out a second mortgage even if the rate is high.
How Do Underwriters Look at Cash out Refinances vs. Second Mortgages?
The approach is the same — they calculate your ability to carry the new debt. However, second mortgage underwriters often apply a tougher formula to calculate your new debt. HELOCs often use the fully indexed rate over the full term. Why? Because most HELOCs offer interest only payments for the first 5-10 years (draw period), then they require that you start amortizing for the remaining 10-20 years (repayment period). Thus when an underwriter wants to see if you qualify for a HELOC, they often apply the most rigorous standard to calculating your underwriting ratios.
Does an Underwriter Take into Consideration That You’ll Be Using the Loan to Pay off Other Debt?
Yes, but only if you indicate on your loan application which debts you’ll be paying off. Otherwise, the underwriter doesn’t decide that for you.
Are You Required to Pay off the Debt at Closing?
It depends. If you have enough income so you qualify for the new higher loan amount with all your existing debt, you are not required to use the proceeds to pay off the debt – you can take the cash and do whatever you want with it. However, if you only qualify for the higher loan amount by paying off the debt, the underwriter will make your refinance conditional upon paying off the debt. Many underwriters will require that the specific items of debt being paid off be listed on your closing statement. The closing agent will be instructed to cut checks to your credit cards or student loan servicer.
There are many different ways to consolidate debt – a personal loan, a new first mortgage, a fixed rate second or a HELOC. Make sure you choose the one that’s right for you.