There are two common kinds of second mortgages. One is known as a "line of credit" and the other is called a "home equity" loan. It's sort of a misnomer, because both kinds of loan require you to have equity in your home. What is equity? It is the value of the house over and above your loan amount on your first mortgage, if you have a first mortgage. If you do not have a first mortgage the "equity" of your home is equal to the value of your home.
For example, let's say you purchase a home listed for $100,000. You have $5,000 for a down payment, so you get a loan for the additional $95,000. Assuming you are approved for your loan, on closing day you have $5,000 equity in the home. However, let's say you have $100,000 for the home, the day after escrow closes you have some major plumbing problems. You decide to get a loan on the home to do some repairs. The appraiser comes out and appraises your home at $180,000. Never mind that the SALE price was $100,000, you actually have $180,000 equity in the home if that is what the appraiser says. The same can go either way. It is possible for your home to go down in value. If you bought your home for $100,000, with a $5,000 down payment and five years later the home is "worth" $50,000 on the open market, you have no equity in your home.
Equity is a funny thing. The market will bear what the market will bear. In my neighborhood many people are walking away from their homes because they perceive a home they purchased for $600,000, now valued at $300,000 is not worth making payments on. They may be right. For now. However ten years from now the house might be worth a million, we just don't know. President Obama used to live in the neighborhood I grew up in, in Chicago. It's called Hyde Park. Back in the day my dad owned a modest brick home there. I would guess it's value went up tremendously the day after Mr. Obama was sworn into office. The secret servicemen who roam the neighborhood have no doubt brought down crime. And, there again, the homes may go down in value when he leaves office.
For myself I bought the cheapest house on the market when the market was over valued which somewhat protected me when the bubble burst. My house probably has gone down in value a little, but it is not below my loan amount. I also put a sizeable down payment in at closing, which is a good idea if your home is not over valued. How can you figure out if a home is over valued? There's no tried and true formula, but consider the cost of actually building a home to give yourself a ballpark figure. If you are paying five times or more the cost to build just to get into a neighborhood you covet, you may want to consider buying an empty lot and building from scratch.
A "line of credit" is like having a credit card based on the equity in your house. An appraiser goes out and decides how much money you qualify for, and you agree with your lender on the rate. After the contract is in effect, you don't owe anything until you tap into it, just like a credit card. Usually though, the lender gives you something like a check book to write your advances out of. If you are approved for $30,000, but you only write yourself a check for $5,000, that's all you have to pay back. Like a credit card there is a minimum to pay back every month, but you don't have to pay it in full. Generally the interest is much much lower than a credit card. Many people like to use this kind of loan to buy vehicles or make repairs on their house. They think because the interest rate is lower than car loan they are doing well.
You are doing well, if you are disciplined enough to pay yourself back in the same timely manner you would pay off a car loan. Two or three years is good, five years a maximum, a seven year car loan is a sorry amount of interest to pay. However, most of the time with a line of credit on a house, the home owner gets ten or even 15, sometimes thirty years to pay off the debt. If you are going to take ten years to pay off the loan, you are really paying too much for the vehicle. In addition, if you default on a regular car loan â all that happens is the car gets repossessed. If you default on a line of credit on your home you have put your living place in jeopardy. It's not a good idea. It IS a good idea to use this kind of loan for repairs and upgrades on your home, especially if you are going to sell it soon. You can pay back the loan quickly with the sale of the house.
The other kind of second mortgage is like a baby first mortgage. It is pretty much the same kind of terms, and conditions. An appraiser comes out to look over your property and decides how much it is worth. If they home is worth $100,000, and you own $80,000 you may well get approved for a 10 or 20 thousand dollar second mortgage, with a shorter term than the first mortgage. Unlike a line of credit all the money is fronted to you right away.
In Hawai'I when I was in the mortgage business in the late 1980's properties were going up in value much faster than inflation. People were pulling money out of their homes at a better rate than any stock or bond was going up in value. Many of the loans I worked on showed that the borrowers wanted to use the money to pay off credit card debt. I would no recommend using secured debt to pay unsecured debt. If you can't pay your credit cards, default on them, don't lose your house.