November 6, 1999,
Revised February 20, 2004, Revised November 30, 2004
"I have a bad credit
card habit, with 7 cards and $30,000 in balances, at rates ranging from
10% to 19%. I have been offered a $35,000 second mortgage at 14% for 25
years to consolidate them, which would substantially reduce my monthly
payments, and there would be no cash required. Is there any reason I
shouldn't do it?"
Quite a few,
in fact.
Don't Consolidate
Low-Rate Debts
The interest rate on
some of your credit card debt is lower than the rate on the second
mortgage. You don't want to replace a 10% loan with a 14% loan. If you do
consolidate, make it partial, leaving the lower-rate debt alone. This
wouldn't apply, of course, if the 10% is an "introductory rate"
that will go above 14% in a short time.
A Second Mortgage
Reduces Your Flexibility
Adding a second mortgage
to the first may hamper your ability to refinance the first when a
profitable opportunity to do so appears. When a first mortgage is paid
off, an existing second mortgage automatically becomes a first mortgage.
This makes it impossible to replace the old first mortgage with a new one
unless the second mortgage lender provides the refinancing lender with a
written statement indicating a willingness to subordinate the second
mortgage to a new first mortgage. Many second mortgage lenders will to do
this, charging fees that range from nominal to extortionate, but some
won't do it at all.
A Second Mortgage May
Extend the Life of Mortgage Insurance on the First Mortgage
Adding a second mortgage
will also extend the period during which you must pay for mortgage
insurance on your first mortgage, perhaps indefinitely. While you do not
fall under the new rules that require lenders to cancel mortgage insurance
when certain conditions are met, lenders will usually cancel a policy
voluntarily if the balance has been paid down appreciably over several
years and is less than 75-80% of property value. But they may not cancel
it if you have added a second mortgage.
A Second Mortgage May
Make You Immobile
If the second mortgage
results in your total mortgage debt exceeding the value of the property,
you may lose your mobility. Suppose you are offered a better job in
another city that would require that you relocate. If you owe $120,000 on
a $100,000 house, selling the house means finding $20,000 in cash to pay
off both mortgages. If you can't find the cash, the only way to relocate
is to default, which would prevent you from buying a house in your new
location. I have received a number of letters from people who have found
themselves in exactly this situation, asking what they can do, and it
depresses me to have to tell them that unless they can find a guardian
angel, they are stuck.
A Second Mortgage May
Be Costly
The upfront charges on
this second mortgage may be excessive. You stopped worrying about these
charges when they told you that no cash would be required, but in fact
they are charging you $5,000. That's the difference between the $35,000
you are borrowing and the $30,000 you need to pay off your debts.
I preach a lot to consumers
financing home purchases about the large savings that are possible if they
shop multiple lenders. But the arguments for shopping are even more
compelling for existing homeowners taking out a second mortgage. The range
of terms offered on a given deal is much wider in this market than in the
market for first mortgages.
Whether or not you can do better
than the offer you have on the table is going to depend heavily on how
good your credit is. If you have
a credit score above 680, you
probably can do better whereas if you are below 600 you probably can't.
You can get your score at www.myfico.com.
