Are There Prepayment Penalties on Second Mortgages?

2nd mortgages are avaliable in a wide variety of forms. Home Equity Loans and Home Equity Lines of Credit (HELOCs) are considered second mortgages. A 2nd mortgage is any loan that is secured by real property that is not in first lein position.

When you take out a second mortgage of any type you should investigate whether there are prepayment penalties on the second mortgage. Usually, if you pay off the loan before a set period of time, regardless of whether you just want to eliminate debt, sell the home, or refinance at a lower interest rate, there is some sort of penalty which may range from a few dollars into the thousands. Before agreeing to take the home equity loan or line your should be sure to understand if there is a prepayment penalty and if so, how is it calculated.

Many lenders have begun disguising the prepayment penalty on their second mortgages, calling it a "bailout fee" or using similar terminology. Basically, they say that they are not penalizing you for closing the loan early, they are simply charging you for the lenders expenses associated with the loan. Either way, if you have to pay extra to close your second mortgage early it is a prepayment penalty.

2nd Mortgages - A Benefit of Homeownership

If you own a home you can use it as collateral for a 2nd mortgage loan. Second mortgages may provide cash for any items you may need such as paying high interest debt, home improvements, college tuition or vacations. The interest rates on 2nd mortgages are typically much lower than credit cards, debt consolidation loans or personal loans.

Second mortgages are secured by your home. The amount that you qualify for will be based on the equity that you have in the home. The amount of equity that you have in the home is determined by subtracting your current mortgage amounts from the value of the property. Depending on your credit you may be allowed to borrow up to 125% of the value of the home. Obtaining a second mortgage for more than the amount of equity you have will lead to you having negative equity, or being "upside down" on the loan. Basically, this means that you will owe more than the perperty is worth.

Usually 2nd mortgages carry a higher interest rate than first mortgages. If you need cash and have significant equity in the home you may be better off with mortgage refinancing than with 2nd mortgages.

125% 2nd Mortgages

Nearly everyone knows that you can obtain 2nd mortgages to tap into your home’s equity for cash. But what if you need cash and you have little or no equity? That is where the 125% second mortgage comes in.

125% second mortgages are frequently used to consolidate all your debts into one low monthly payment or put significant cash into your pocket. Here is an example of how they work:

Suppose your house is worth $250,000 and your current mortgage balance is $185,000. Typically, cash-out refinances allows you to borrow up to 80% of the value of the home. In this case, the maximum loan amount would be $200,000. Since you already owe $185,000 and there will likely be closing costs on the new loan, you are not able to obtain a significant amount of cash. With the 125% second mortgage you can take a loan for up to (you guessed it) 125% of the value of the home. In this case the total loans on the property could equal $312,500. Since you already owe $185,000 the 125% second mortgage could be in an amount up to $127,500. No that’s a significant amount of cash.

Most 125% second mortgages will charge you an upfront funding fee in addition to your regular closing costs. The upfront funding fee may be as high as 10% of the loan amount, or $12,700 in our example. Additionally, the interest rate you pay on the loan will be significantly higher than the interest rate on a generic cash-out refinance.

The extra fees and higher rates are a result of the increased risk to the lender. If you default on the loan the lender will foreclose on the home and sell it to recoup their funds. In the event of a foreclosure the lender is left owning a property that is worth less than the loan that was associated with it. That risk of loss is passed along to you, the borrower.

It is easy to see the risk to the lender. The risk to the borrower is not as obvious. You know that if you default on the loan you face foreclosure and losing your home. That goes along with any mortgage. Another risk is that you may be tied to the home for longer than you wish, or have to pay significant money out of pocket if you want to sell. In our example above the home was valued at $250,000 and the loans against it totaled $312,500. If you were to sell the home at market price you would have to spend $62,500 out of pocket to clear of the debts on the property, and that is not including any closing costs or moving expenses.

125% 2nd mortgages should be entered into carefully. Some of the situations where they make sense may include times when housing values are rising quickly, when you intend to keep the home for many years, when the money will be used for improvements or additions that will significantly increase the value of the home.

Used properly you can receive great benefits from 125% 2nd mortgages.