Do you owe a large amount of debt, be it credit cards, payday loans, or lines of credit? If so, you may have considered getting a second mortgage to pay off debt.
Consolidating debt using another mortgage can be a wise move for some people, especially since mortgage loans offer cheaper interest rates than most other forms of credit. However, that’s only sometimes the case. Replacing your high-interest debts with a second mortgage can potentially worsen rather than strengthen your financial situation. It can even endanger your home.
In this guide, we’ll show you how a second mortgage works and what it takes to qualify for one. We’ll also explain the advantages and disadvantages of getting one and how to know if it’s the best debt relief option for you.
What is a second mortgage, and how does it work?
A second mortgage is an additional loan you can take out on a home you already have a mortgage on. It allows you to access more credit, which you can use as you please and repay through regular monthly payments, just like your first mortgage. And, like your first mortgage, your home serves as collateral for the second one.
If you qualify for second mortgage financing, your lender will deposit a lump sum payment into your bank account, which you must pay down over a predetermined period with interest. Unlike a home equity line of credit (HELOC), you cannot reborrow the principal after you pay it off.
Most second mortgages in Canada offer short terms ranging from a few months to a few years. They typically come with fixed interest rates, though some lenders offer variable rates.
Interest rates on second mortgages tend to be higher than those on first mortgages, as they pose more risk for lenders. The reason is that a primary mortgage lender has priority over the collateral (your home) should you default on your payments.
Top reasons to get a second mortgage
Here are some situations were getting a second mortgage may be ideal:
Debt consolidation. A second mortgage can be a great way to combine multiple debts under a single loan with affordable monthly payments. You can snag a lower interest rate with a mortgage than most unsecured debts.
Pay for a large purchase. Are you looking to revamp your kitchen through a large-scale renovation? Or maybe you wish to go back to college to upgrade your skills? A second mortgage can help you pay for large expenditures you cannot afford or want to avoid financing with double-digit loans, such as credit cards.
Finance a second property. Suppose you have plans to acquire another property, such as a vacation home or a condo to rent out. In that case, a second mortgage can provide you with the cash for a down payment.
Pay for everyday expenses. Are you overwhelmed with bills or facing a hefty emergency expense? A second mortgage can provide you with a healthy cash infusion at a reasonable rate to help you through a financially difficult time. Some people also acquire a second mortgage from another lender to catch up with past-due payments on their first mortgage.
How much can you borrow through a second mortgage?
Whether or not paying off your debts using a second mortgage is a savvy move hinges on how much you can borrow. In Canada, the maximum amount you can borrow through a second mortgage is 80% of your home’s value minus your outstanding first mortgage balance.
The 80% rule applies to traditional, federally-regulated mortgage lenders like Big Five banks. Lender firms not legally bound by federal laws may provide you with more borrowing power, perhaps up to 90% of your property’s market value.
However, remember that your finances will also influence lenders’ decisions on how much credit to extend. When reviewing your application, lenders will examine your credit score, current debt obligations, and income to determine your borrowing limit.
How do you qualify for a second mortgage?
There are a few eligibility criteria you must satisfy if your goal is to secure a second mortgage to pay off debt:
- Home equity. Naturally, you’ll need to have sufficient equity in your home. The minimum requirement is 20% to 25% for prime lenders, like Canada’s major banks. However, private lenders may ask for less and be willing to grant you financing if you have only 10%. The more equity in your home, the higher your chances of securing a second mortgage.
- Good credit score. There’s no escaping the fact that your credit must be in good shape to qualify for a second mortgage. What’s considered “good” will vary from lender to lender, but the number is around 650 for traditional financial instructions. Given that second mortgages are inherently riskier than first mortgages, it’s reasonable to assume most lenders won’t accept a score below 600.
- Reliable income. A lender will want proof that you earn a stable and adequate income to service your mortgage payments.
- Low debt-to-income ratio. Each lender sets its acceptable debt-to-income ratio, but a wise starting point is a maximum ratio of 44%, which is the standard for a CMHC-insured mortgage. However, many lenders would likely set a lower limit since a secondary mortgage is riskier than a primary mortgage.
- Home appraisal. Since home equity is the primary factor determining your borrowing power, your lender may request a current home valuation.
What if you have bad credit?
Obtaining a second mortgage is still possible if your credit is in the dumps. Private lenders will often give lower credit scores a pass, as they emphasize your home’s equity more when deciding whether to approve your application.
However, you may not receive a favorable deal on the interest rate, as the lender will charge more as compensation for the extra risk they bear in lending to you. Sub-prime and private lenders, for example, can sometimes charge interest rates that rival those on credit cards. As a result, you could wind up paying more and worsening your debt situation.
The pros of getting a second mortgage to pay off debt
A second mortgage offers several advantages:
Low interest rate. The interest rate on a second mortgage is considerably lower than that on other loans like credit card debt and unsecured lines of credit. By merging your high-interest debts under a second mortgage, you can drastically lower your interest expenses and pay off your balance sooner.
Stable payment schedule. Most second mortgages come with fixed interest rates, meaning your payments will never change during your term. You don’t need to worry about rising rates, as you would with a HELOC.
One monthly payment. Tired of juggling multiple bills and debt payments each month? An extra mortgage will allow you to consolidate everything under one loan, simplifying your payment schedule.
Large borrowing capacity. A second mortgage can give you tremendous borrowing power if you own a large house with significant equity.
Easier than refinancing. Refinancing your mortgage is another way to consolidate debt, but it’s usually a more tedious and expensive option. Plus, you may incur a hefty prepayment penalty by doing so.
The cons of getting a second mortgage to pay off debt
There are several drawbacks to keep in mind if you’re considering taking on an additional mortgage:
Risk of foreclosure. Failing to keep up with your second mortgage payments will put your property in danger of foreclosure, as it’s a secured loan.
Fees. Some expenses you may have to pay when taking on an additional mortgage include legal fees, appraisal fees, title insurance, and title search fees.
Strict qualification criteria. To qualify for a second mortgage, you must satisfy lenders’ income, credit score, and debt-to-income ratio requirements.The standards can be exceptionally high, especially if you hope to secure a low rate from a major bank like RBC. If your finances are in poor shape, you may not get approved. In addition, you’ll need enough equity in your property for lenders even to consider your application.
What to consider before deciding to get a second mortgage to pay off debt
Depending on your situation, getting a second mortgage can be a financial blessing or a disaster. Below are six questions to ask yourself before filling out mortgage applications.
- Can you borrow enough? First, you need to determine if you have enough home equity to pay off your debts.Calculate the maximum amount of money you could borrow via a second mortgage (your home value x 80%, less your outstanding mortgage). Compare this figure to your total debt obligations to see how much you can consolidate.
- Can you secure a deal that will save you money? Next, you’ll want to research whether obtaining a second mortgage makes financial sense. In other words, will it help save you money on interest and allow you to pay off your debts faster? Calculate the average rate you’re paying on your existing debts and determine how long it will take you to pay them off. Then, consult a mortgage broker or inquire with various mortgage lenders about the interest rates you could qualify for based on your credit history, income level, etc. If you’re not eligible for financing at a lower rate than your current one, a second mortgage isn’t worth acquiring.
- Can you afford the monthly payments? Determine the size of your monthly second mortgage payment. Can your budget accommodate it? Even if you can secure a low rate, you may get stuck with large payments if the repayment period is short.
- Are you prepared to put your home at risk? Never forget that your home functions as collateral for a second mortgage. Ask yourself if you’re comfortable with your property securing two mortgages.
- Can you keep up with your payments if you lose your primary income source? How confident are you in staying up to date with your extra mortgage payments should you get laid off? Do you have a sizable emergency fund, a side hustle, or an income-earning spouse or partner that can help you weather tough financial times?
- Do you plan to live in your current home for a long time? A second mortgage is more suitable for those who plan to live in their home for an extended period. If you anticipate selling your home in the near future, you’ll need to pay off your second mortgage in full following the sale. This scenario won’t be an issue during a hot real estate market. But suppose your home value declines due to an economic downturn. In that case, you may have insufficient equity to pay off your first and secondary mortgage.
Alternative debt relief solutions available in Canada
If you answered “no” to the six questions in the previous section (especially the first three), a second mortgage is likely not the optimal solution for dealing with your debts. Swapping high-interest debts for a single high-interest second mortgage will only worsen your situation, plus put your home in danger of foreclosure.
In that case, it’s time to explore other paths. A great place to start is by implementing DIY debt relief tactics. But if your debt problems are already too insurmountable, you might wish to consider the following debt relief options:
Consumer proposal. A consumer proposal is a form of debt settlement that can reduce your debts by up to 80%. It’s a legal process where you consolidate your unsecured liabilities and negotiate a new payment plan with your creditors. You’ll make interest-free payments over five years. Besides slashing your debt, a consumer proposal will grant you legal protection from creditor actions like lawsuits and wage garnishments. And your home will never be in danger of foreclosure.
Bankruptcy. Filing for bankruptcy is a legal process that will completely wipe out your unsecured debts. In return for forgiveness of your debts, you’ll need to surrender a portion of your assets to your creditors. However, you won’t have to give up everything; some key exemptions include your home and car. Like a consumer proposal, bankruptcy shields you from legal action by creditors.
If you’re wondering whether a second mortgage or another form of debt relief is the best way to solve your debt problems, book a free, no-obligation consultation with David Sklar & Associates. For over two decades, we’ve been helping Canadians squash their debts and gain a fresh financial start. We can help you, too!
