Have you ever heard of a second mortgage?
Second mortgages give you the cash flow you need to spearhead new investments and business opportunities. From revamping tired commercial spaces to acquiring investment properties to starting your dream business, the potential uses are limitless.
If you have heard of second mortgages, you might have some strong opinions. Second mortgages have a terrible reputation in the world of personal finance (thanks, GFC!). But like any financial tool, second mortgages come with their own set of costs and benefits. In this article, we’ll take you on a journey through second mortgages, exploring how they work, when they make sense, and when they don’t.
What is a second mortgage?
A second mortgage is a loan that uses one of your already mortgaged properties as security. Taking one out allows you to access the equity in your current property asset, such as a warehouse or retail space, to secure additional funds.
As the name suggests, a second mortgage is secondary. It sits behind your first mortgage. If you don’t repay your debts and your property is foreclosed, your first mortgage will be repaid before the second. This increases your risk significantly if you don’t have a steady cash flow. You will recoup a smaller share of the pie if your property is sold off.
It is important to distinguish between a second mortgage which is essentially an extra ‘home loan’, and a second mortgage for business purposes as they are treated differently in the eyes of the law.
Understanding second mortgages.
One of the biggest perks of a diversified property portfolio is the additional equity you build. Second mortgages allow you to leverage this equity and tap into the value of your property without selling it. Two primary structures of second mortgages for personal use are equity loans and lines of credit.
(1) Equity Loans: This type of loan provides a lump sum of money you repay over time with fixed monthly payments. As it is commonly used to cover short-term expenses, the total loan value is much smaller than on a first mortgage. Interest rates on equity loans also tend to be higher than those on your primary mortgage, but lower than unsecured lending, like credit cards.
(2) Line of Credit: A line of credit functions more like a credit card than a loan. They are a revolving source of funds from your finance provider. You are given a credit limit against which you can borrow, and you only pay interest on the amount you borrow. This gives you much-needed flexibility. You can borrow, repay, and borrow again during the ‘draw’ phase before entering the repayment phase.
When second mortgages make sense.
Like most products in finance, second mortgages are a broad church that can serve all kinds of businesses.
(1) Property improvements: Whether you’re looking to revamp a commercial retail space or give your business premises a new lease on life with a slick renovation, second mortgages can provide the necessary funds. Not only do these improvements add to the value of your property, lowering your LVR and driving capital appreciation, but they can also enhance the quality of life for tenants and staff using the property. Many property investors will use a second mortgage to flip a property before sale. A second mortgage that funds a $50,000 property improvement might add $75,000 to the sale price, delivering a clear-cut ROI.
(2) Debt consolidation: While debt itself isn’t bad, unmanageable debt can quickly snowball and derail your financial goals. This is where debt consolidation comes in. By using the equity in your property to pay off higher interest debts, you can reduce the big by-lines that keep your finances in the red. A simplified financial life, with a single, lower monthly repayment, primes you for long-term success.
(3) Investment opportunities: Savvy investors can use a second mortgage to accelerate their property plans. Refinancing an investment or commercial property loan allows you to access the usable equity on a property, which can then be used as a deposit to buy additional property. Second mortgages could also be used to renovate or ‘flip’ an investment property before selling. Even a small investment could ensure you realise a stronger capital appreciation. Given the lower seniority of second mortgages, this strategy carries more risk with it and should be pursued by seasoned investors.
(4) Business growth: By tapping into the equity in your first property, a second mortgage allows you to secure the capital needed to fund your business’ launch, expansion, or crucial reinvestment. The applications are varied enough to suit any business. Whether financing equipment purchases, hiring talent, or expanding your marketing efforts, the lump sum or flexible credit line offered by a second mortgage can provide the financial boost your business needs.
What to be careful of.
While second mortgages offer many benefits, they also have some potential downsides. Chief among them is the risk of losing your secured property. You put your property on the line when you take out a second loan you cannot exit. If you fail to make the required payments and your serviceability crumbles, you risk losing the property through foreclosure. This is why you should have robust serviceability before you apply. Stable cash flow and good income, from investments or your business operations, put you in good stead to pay on time.
Furthermore, you accumulate more debt with a second mortgage, especially if you use the funds for non-essential purposes. Be cautious about over-leveraging your property equity, as it can exacerbate financial stress in the long run.
To help mitigate this risk, we always recommend a detailed exit strategy. How do you plan to repay the loan? What happens if you can’t meet your regular repayment or your circumstances change? A common exit strategy is selling the property or refinancing. However, these should not be last-ditch strategies. Know your exit early.
Tips for using second mortgages wisely.
(1) Shop around: As second mortgages are more expensive than firsts, it pays to shop around. Don’t settle for the first lender you come across. Compare multiple lenders’ rates, terms, flexibility, and fees to find the best deal. If you’re overwhelmed, reach out to a broker who can tell you your options.
(2) Plan ahead: Before taking out a second mortgage, have a well-defined plan on how to use the funds and how to repay the loan. It pays to be realistic. Take stock of all the income you’ll generate in the period and how you’ll adjust if things don’t go according to plan.
(3) Consider professional opinions: Taking out a loan is one of the most significant financial commitments that a business can make. If your situation is complex or you want more certainty, consult your accountant, a financial advisor or a broker to understand the implications of a second mortgage.
Second mortgages can be a powerful tool when used wisely and responsibly. They provide access to your equity, allowing you to achieve your financial goals and grow your investment portfolio.
However, they also come with risks that should not be taken lightly. Before diving into a second mortgage, consider your financial situation, serviceability, and exit strategy carefully. At Sparrow Loans, we firmly believe borrowers should have an exit in mind before they’ve even considered entering a loan facility.
Call us today if you think a second mortgage could be for you.
Note: Sparrow Loans only offers second mortgages to company borrowers for business purposes.