Let me tell you a cautionary tale about taking out a second mortgage.
I got into a lot of financial trouble in my twenties. Even though I bought my first home on my own at 23, my finances were a mess. I was stuck in a big-time credit card debt trap. My only saviour was the small bit of equity that thankfully built up in my home (I only put 10 per cent down on my purchase).
I knew my bank wouldn’t lend me any more money. I needed 25 per cent equity in my home to be considered for a home equity line of credit, plus my credit score had taken a major hit.
Alternative lenders such as Home Trust and Wells Fargo were offering consolidation loans at 8 per cent interest and their lending criteria were much looser: I only needed 10-15 per cent equity in my home to qualify. So I added up all of my outstanding high interest rate debt and placed a second mortgage on my home to consolidate those debts into one lower interest rate and payment.
What is a second mortgage?
A second mortgage is just what it sounds like: a loan against a property that already has an existing mortgage in place. Interest rates are much higher with second mortgages because of the risk involved in being second in line. The first mortgage gets priority if a homeowner defaults on his or her payments.
Someone with a good credit score and a lot of equity built up in their house can set up a home equity line of credit with little trouble and access the funds for a renovation, vacation, or to consolidate other debts.
In my case, I had neither good credit nor much equity in my home. I had to resort to an alternative lender to set up a second mortgage and bail me out of my credit card trap. I paid just over $800 per month over a three-year term.
What are some of the pitfalls of a second mortgage in Canada?
In addition to trust companies, private lenders also finance second mortgages for borrowers who are turned down by banks and other lending institutions.
The pitfall with any consolidation loan or second mortgage is that the borrower uses the loan to pay off his or her credit cards and then proceeds to rack up the cards again and borrow even more. It results in an even worse situation overall.
Another concern is the fact that you are taking unsecured debt and securing it with your most valuable asset. If something goes wrong, you could lose your house because of your credit card debt. You need to be especially careful in this situation.
Thankfully, that didn’t happen with my story. I managed to dig my way out of that $30,000 mistake
and get back on my feet. The monthly payments forced more financial discipline on my part and the sheer embarrassment of having resorted to an alternative lender and second mortgage was enough to scare me straight.
A second mortgage can be a good alternative for those with poor credit and not enough home equity to qualify for a traditional home equity line of credit. Just be sure not to fall back into the debt trap. Make a plan to pay off the second mortgage as quickly as your budget allows.
As with any loan, you need to show proof of steady and dependable income to qualify. The higher your credit score, the better your chances at a decent interest rate. And finally, the more equity you have in your home, the better chance of qualifying for a second mortgage.