5 ways second mortgages can torpedo your finances

What Is a Mortgage?
What Is a Mortgage?

Remember the real estate boom-and-bust that left many homeowners in foreclosure? Whew, glad that's behind us, right?

If you're like some homeowners, you've greeted the U.S. economic upturn by seeking out a home equity loan – basically a second mortgage (not to be confused with a home equity line of credit). Low interest, lump sum of cash, what's not to like, right?

Well, one thing could be that you're unwittingly setting yourself up to fail and, yes, face foreclosure. Consider that DS News, a trade publication serving the mortgage industry, noted that the default rates for first and second mortgages last year were rising. Yes, that could happen to you.

But second mortgages can make sense, as long as you're cautious.

First, let's talk basics. A second mortgage allows the borrower to obtain a lump sum of cash at a fixed rate – it averaged 6.2 percent in January according to The Wall Street Journal. And with the staggering average costs of home renovations — more than $17,000 for bathroom remodeling and just under $60,000 for kitchens according to Hanley Wood Media — some owners have no choice but to borrow against equity to maintain their homes.

Once approved, the cash — generally a much larger sum than can be obtained from credit cards or personal loans — can be used at the homeowner's discretion. And that, for some, is the problem. Yes, mortgage debt is often thought of as "good debt," and it often comes with some tax advantages, such as the interest can be deducted from your taxes.

But there are a number of downsides to borrowing money against a home, some of which can completely sink your finances. Before you pursue a second mortgage, consider these pitfalls:

Closing costs may be pricey: Prepare to pay $4,000 or more for closing costs on a $200,000 mortgage, cautions Wall Street Journal columnist June Fletcher writing for HouseLogic. That cost may make sense if you are paying for home improvements or college — true investments — but if the money will be spent for extravagances such as a flashy car or exotic vacation, rethink it. Even when you can afford the costs, Fletcher recommends asking your current lender if it offers discounts on closing costs for those seeking second mortgages. And, certainly, shop around for the best closing costs and interest rates.

You could lose your house and more: Elizabeth Weintraub, a San Diego-based Realtor who covers refinancing issues for About.com, told The Fiscal Times that first mortgages, in some states, are "non-recourse" loans. Basically that means you forfeit your house if you fail to pay. Second mortgages, in some states, are different. Nonpayment may result in you losing your home and other assets if the sale amount doesn't cover your loan. And that, in turn, makes it very difficult to secure another residence, noted PointWest Credit Union. Think carefully about this before you use a second mortgage for such expenses as bankrolling a business, which could produce wobbly financial footing.

Debt collectors may come knocking: If you do default on the second mortgage, some states allow debt collectors to contact you until the loan is satisfied, said Fletcher. Of course, this activity will be reported to credit agencies and add a large, black mark to your credit history.

Future financial options are limited: Those that obtain second mortgages have little chance of obtaining extra financing in case of emergencies, noted The Truth About Mortgages.com. No one thinks they'll encounter legal or employment issues, but those who do have few financial options if they've already secured second mortgages.

Unethical lenders may gouge you: Let's say you really do want to use a second mortgage for home improvements. Some home-improvement contractors may suggest financing options. Beware, cautioned Fletcher. Lenders are supposed to follow guidelines that include keeping you within a certain range to make sure your income can support your debt. Do not be pressured into signing with any lender before you shop and determine the credibility of the lender. And, of course, don't agree to overstate your income or otherwise behave in a dishonest manner.

Related: 13 features homeowners want the most

What's your experience with a second mortgage? Share with us in comments below or on our Facebook page.

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