Costly home improvements frequently cost more than the cash you have available. There are two financing options available to you when this situation exists. You can either refinance the home to include the cost of the improvements into the loan amount or an alternative to this is getting a second mortgage.
In this case, you keep your original loan and add another on top of it called a "second" mortgage. This second might have various names such as a "home equity loan," "home improvement loan," or "revolving line of credit."
You can also get a third mortgage if you already have two. Sometimes you can get even a fourth mortgage. However, because the risk for the lender increases with the higher number of mortgages, usually interest rates also increase. (The risk increases because in any foreclosure the lowest-numbered mortgage is paid off first. If there's any money left over, the next lowest mortgage is paid, and so on. Higher-numbered mortgages risk not getting paid off at all!)
The advantage of getting a second mortgage is that you do not have to disturb the original first mortgage. For example, perhaps interest rates have gone up since you purchased. Your mortgage carries a 5-percent interest rate. But new firsts are at 6 percent.
A new second mortgage might be at 7 percent. Depending on the amount borrowed, it might be cheaper to obtain the higher-interest second, than a new higher interest first.
The way to determine whether it pays to get a new second or a new first is to determine the blended interest rate. For example, if you already have a large first mortgage of $100,000 at 5 percent and can get a new smaller second mortgage of $50,000 at 7 percent, the blended rate is roughly 5.5 percent. This is better than getting a new first mortgage of $150,000 at 6 percent.
You have to recalculate each time for the amount of the mortgage and the interest rate. Many online lenders (such as eloan.com) have calculators to help you with this. Also, we're assuming your existing first is only a few years old. If it's an older amortized loan, the principle has gone down and there's less interest to be paid.
While it sometimes makes financial sense to refinance or secure a second mortgage for a home improvement, we suggest you approach all such endeavors with a strong dose of common sense keeping in mind that your goal should be that your equity percentage of the total value of your home after the loan and improvements remains about the same as it was before the transaction.
This article continues in Understanding a Second Mortgage.
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