Question

If I decide to take a second mortgage or home equity loan on my house to increase funds available for my children's tuition. I will need to understand the deductibility of the interest and any limitations that exist.

Answer 1

Second Mortgage

A second mortgage is a lump sum loan amortized like your first mortgage. It is simply a second loan behind your first mortgage and the closing costs are generally lower than they were on your first. This type of loan is similar to your first mortgage when it comes to the interest rate and offers a fixed rate. It can be used for one-time purchases, such as a large home improvement project or the restructuring of your debt. The interest rate is usually higher than the rate on your first mortgage, but the qualification process isn’t as daunting as when you first purchased your home. You will need to document your income and your credit must be good in order to qualify for this type of loan, but beware of loans offering zero or no-equity that allow you to borrow up to 125 percent of the home’s value. The zero and no-equity types of loans tend to have stricter qualifying standards and the interest rate will be higher.

How Does a Second Mortgage Work?

A second mortgage is also attached to your home. It operates differently, though. The loan is paid out in one lump sum at the beginning of the loan. The payment amount and the term of the loan are already set. Once the loan is paid off, then you would have to open up a new loan to borrow against the equity in your home again.

Limitations of Second Mortgage loan:

Interest rates

Any time you borrow, you’re paying interest. Second mortgage rates are typically lower than credit card interest rates, but they’re often slightly higher than your first loan’s rate. Second mortgage lenders take more risk than the lender who made your first loan. If you stop making payments, the second mortgage lender won’t get paid unless and until the primary lender gets all of their money back. Because these loans are so large, the total interest costs can be significant.

Risk of foreclosure

One of the biggest problems with a second mortgage is that you have to put your home on the line. If you stop making payments, your lender will be able to take your home through foreclosure, which can cause serious problems for you and your family. For that reason, it rarely makes sense to use a second mortgage for “current consumption” costs. For entertainment and regular living expenses, it’s just not sustainable or worth the risk to use a home equity loan.

Home Equity Loan

A home equity loan, otherwise known as a home equity line of credit (HELOC), will offer an adjustable rate of interest and is used for purchases over time, such as college tuition payments or

multiple home improvement projects. Often, you will find that a second mortgage is referred to as a home equity loan, which can cause confusion as to which type of loan you obtain. Be aware of this terminology and read the fine print if it is truly a second mortgage you want rather than a line of credit. The HELOC loan offers a variable rate of interest, continuous use of funds, and future amortization. Often, you will be given a credit card to access the funds of a HELOC and there will be a limit to how much you can use, depending on your qualification and the property value of your home.

How Does a Home Equity loan?

A home equity line is a revolving line of credit. The bank opens the credit line and the equity in your home guarantees the loan. A revolving line of credit means that you can borrow up to a certain amount and make monthly payments. The payments are determined by how much you currently owe on the loan. Once you have paid off the money you can borrow it again without applying for another loan. It is similar to a credit card in that way. It is important to remember that you miss payments on your home equity loan; you do put your home at risk.

Limitations of home equity loan:

Home equity loan fixed-rates are higher than what you'd pay for a fixed-rate primary mortgage. So you may be better off with a cash-out refinance, particularly if you can also reduce your primary mortgage rate in the process. A cash-out refinance may also be a better option if you need to borrow a large sum of money and would

Depending on where you live, you may need to pay a mortgage recording tax when you take out a home equity loan or HELOC. Such taxes are based on your loan amount, so the more you borrow, the more you have to pay.

HELOC rates are adjustable during the draw period, your monthly payments could end up being higher than you expected if rates rise before you reach the repayment phase.

Deductibility of interest

The Tax Cuts and Jobs Act of 2017, enacted Dec. 22, suspends from 2018 until 2026 the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the taxpayer’s home that secures the loan. Under the new law, for example, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same loan used to pay personal living expenses, such as credit card debts, is not. As under prior law, the loan must be secured by the taxpayer’s main home or second home, not exceed the cost of the home and meet other requirements.