What are HELOCs and Second Mortgages?
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Last week I wrote a post on Five Cent Nickel on the merits of paying down debts with a HELOC. Some people have turned to it as an option in paying down their high interest debt. I want to be a bit more specific today and discuss what HELOCs and second mortgages are and how people use them. 
What is a HELOC?
Home equity line of credit or HELOC is a line of credit based on the equity you've accumulated with your property. Lenders calculate equity based on what your home is worth and what you owe on the mortgage loan.
This specific line of credit can be useful for short-term borrowing. Right now, Bankrate reports that interest rates for HELOCs are around 4.8% – 5.1%. Being low, some people open an account and use it as part of their emergency fund.
There are some disadvantages to having a HELOC. With the real estate market down in some areas, homeowners are seeing their equity dwindle. Some lenders have also reduced or frozen accounts, so it may not be a great fail-safe that people think it is.
How Does a Second Mortgage Work?
Besides obtaining a HELOC, homeowners have used second mortgages. Just as it sounds, a second mortgage loan is another loan on your property in addition to your primary or first mortgage. You can multiple loans on the same property. That's a risky proposition,though, because if you can't make payments on all of the lenders, technically any of them can foreclose on your home.
Some first time homeowners who have a smaller down payment use a second mortgage as a method to avoid mortgage insurance. Existing homeowners sometimes take out a second mortgage to pay off high interest debt. The advantage with this option is that you receive the money in one lump sum and it is typically at a fixed interest rate.
Thoughts on HELOCs and Second Mortgages
Have you used either of them to pay down debt? Have you used a HELOC as an emergency fund? How did it work out for you? I've heard some older Americans are using reverse mortgages, but they have their own pitfalls. What's your take on it?
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I currently use my HELOC, which costs Prime + 1.25% = 3.25% to pay off my main mortgage. It’s a pretty good arb, which has worked for the past two years. Now, I’m just refinancing the whole thing since rates went down so much.
Everybody should refi!
I’d be careful about using seconds or HELOCs to consolidate non-housing debt. It was immensely popular a few years ago, but getting too deep in debt on your home isn’t without risks–not any more. Many of the people who are in trouble on their homes right now are the ones who took the debt consolidation/refinance pattern too far.
One of the problems with debt consolidations is that it’s mostly about transferring debt from one pile to another, which doesn’t change your fundamental debt structure. If you do go the consolidation route, have a plan to pay off the new loan a.s.a.p.
When I was in the mortgage business the typical pattern with 2nds and HELOCs was to “payoff” high interest rate debt with the new loan, but two years later most of the same people would have fresh high interest rate debt–plus the 2nd or HELOC taken earlier.
@Sam: I know you’re on a refinance campaign and I’ve had several friends do it. Just run the numbers and see if it’s right for you. Great deal you have/had on the HELOC!
@Kevin: Thanks for the pointing the risks out. That’s the dark side of using HELOCs or 2nd mortgages. I pointed out in my FCN post that you’re putting your house on the line so you better have a plan if you decide to go this route.