The 125% Mortgage
By: Gary Foreman
"Reduce your monthly payments! Save money and be back in control of your debts." That's the pitch you hear for second mortgages that allow you to borrow up to 125% of the value of your home. And as more people see their credit card debts creep up, they're wondering if this type of loan could be the answer to their problems. So let's take a look at the 125% second mortgage.
What makes these loans look so attractive? They claim a couple of benefits. First, the interest rate charged is lower than on a credit card account. And rates have trended upward on credit cards. Even with good credit it's not unusual to be paying 15% or more on your credit card balance.
The other lure for borrowers is that the second mortgage comes with a lower monthly payment. They typically run 15 to 30 years. So borrowers are only repaying a little bit of the principal each month. It's not unusual for someone who has credit card balances to reduce their monthly payment by one third if they transfer to a second mortgage.
Finally, potential borrowers are reminded that some or all of the interest expense could be deductible from their federal income taxes. Pretty tough combo to beat, right?
Well, maybe not. Take a good, hard look at what's happening. To begin with, most companies that issue second mortgages will charge you to borrow money. And, they're not bashful about asking for it. For instance, one company offers a rate of 12.25% (13.9% APR). But to get that rate you need to add 10% to the amount borrowed. If you want a lower rate, you'll pay even more.
Let's look at an example. Suppose five years ago you bought a home for $100,000. You put down 10% and took an 8% mortgage. We'll further assume that the home has appreciated and is now worth $110,000.
But lately you've been running up a few credit card debts. Actually more than just a few. If you add them up it totals about $30,000. So what happens if you use a 125% second mortgage to consolidate those debts?
To start you'll pay a $3,000 premium to borrow $30,000. And if you add the $33,000 in new debt to the balance you still owe on your first mortgage, you now owe $118,500 on a home that's worth $110,000. But that's not much more than the house is worth. Well within the 25% that the mortgage company would lend you. No problem, you think.
On the plus side, you have reduced your payments. Depending on how much interest the credit card companies were charging you could be saving $250 each month in minimum payments. So that's good.
Now for the downside. You're stuck in your home. Forget about moving or refinancing for lower rates. Even assuming that the house appreciates 3% each year, if you continue to make the minimum payments on both mortgages it'll be 2 years before you owe less than the house is worth.
Selling it is even tougher. Your real estate agent will want a 6% commission. You'll need to make payments for four years to be able to sell it and pay the commission. And you'll walk away with empty pockets. If you'd like a 10% down payment for your next house you can plan on making those payments for 6 years before you put your house on the market.
And that's if home prices go up. There's no guarantee of that. There have been many times when real estate prices slumped for a few years. In that case you could be stuck in your house forever.
Next, let's look at the amount of interest that you'll pay. Yes, the credit cards do carry a higher rate. But because you pay them off more quickly you only end up paying about half as much in interest expense. On a loan this size you could write checks for an additional $10,000 to the mortgage company over the life of the loan.
There is a way to reduce that. Switch to the second mortgage and continue to make the same monthly payments as before. Instead of making the $354 payment required by the second mortgage, continue to make payments of $600 each month. You'll return to a positive equity position in just 15 months. In about 4 years you'd be able to sell your house, pay the real estate commission and still have 10% down for your new house.
So what's the bottom line? Second mortgages work best if three conditions are met. First, that the second mortgage doesn't hit you with an overly large origination fee. It's hard to come out ahead when you add 10% to the amount you already owe.
Second, you need to plan on paying off the second mortgage as quickly as possible. If you pay just the required amount each month you'll be giving away a lot of money in interest over the years.
Thirdly, you'll need to have self-discipline. Just because your credit cards show a zero balance doesn't mean that you have extra credit to use. Your new goal should be to pay off the entire account balance each month. Consider anything less to be a failure. Letting your account balances to creep up again is the first step to financial disaster.
If all three of these conditions aren't met, a second mortgage is a bad idea. And one that has you borrowing more than the value of your home is especially dangerous. Don't look at this as a way to reduce your monthly payments.
On the flip side, if you can lower your interest rate without paying a large origination fee and will continue to make the same payment every month, a second mortgage can be a way to reduce the cost of your debt.
You'll surely hear more ads encouraging you to consolidate your loans into a second mortgage. And they'll make it sound easy and safe. But, the wise consumer will consider all the possible consequences before you sign the contract.
Gary Foreman is a former Certified Financial Planner who currently edits The Dollar Stretcher website (www.stretcher.com) You'll find hundreds of free articles to stretch your day and your budget.