Second Mortgage

Typically, most first time home buyers get their home buying and financing information from friends and relatives who have purchased a home in the past. When it comes to second mortgages, however, many people have had little or no personal experiences with the subject. Therein lies the reason second mortgages have a bad rap. After all, if one mortgage is bad enough, two mortgages must be worse. In reality, a second mortgage may be a better financial decision for certain individuals and the only option for many buyers stretching to afford the home of their dreams.

By definition, a second mortgage is a lien on a property that is placed behind a first mortgage. In case of mortgage default and subsequent power of sale, the first mortgage gets paid out in its entirety plus any legal costs before any left over goes to the second mortgage payout. Due to the increased risk associated with this type of lending, the interest rates on second mortgages are usually higher.

Canadian legislation dictates that a bank can lend up to 75% of the value of a home without placing default insurance on the loan. Default insurance (also known as CMHC or GE mortgage insurance) is protection for the lender with the cost of the premium borne by the borrower. The amount of the premium is established based on a sliding scale (between 1.25% - 3.75% of the mortgage amount). Second mortgages are the answer to eliminating the need for default insurance.

Consider this example of a home purchase with a purchase price of $225K with $30K used as a down payment. The total mortgaging required to complete this transaction is $195K. Since the financing required is greater than 75% of the value of the home (87%), the mortgaging needs to be either insured against default (also known as a hi-ratio mortgage) or a first & a second mortgage combination.

In our example, using the default insurance option, the premium is 2.5% or $4,875, which is usually added to the mortgage. This increases the financing to $199,875K with a monthly payment (calculated at 7.5%) of $1,462.20.

Option two is to take a first mortgage to 75% of the value of the home or $168,750K (payment @7.5% is $1,234.50 per month) and add a second mortgage for $26,250K (payment @12% is $270.87 per month). The combined monthly payment for option two is $1,505.37 or $43.17 more per month, than option one.

However, the results at the end of a five year term suggests that there is very little difference between the two options and in fact, in our example, taking a second mortgage works out better for the borrower. The mortgage balance at the end of the term, for the default insured mortgage, is $183,094.36. The balance, after the same timeframe, in option two is $179,640.77. Even when you add the overpayment of $43.17 per month, ($2590 over 5 yrs) the balance is still lower than in option one.

So, the moral of this story is; don't be too hasty in jumping to negative conclusions about second mortgages. They may make the difference between being able to buy the home of your choice rather than settle for second best.