Second Mortgage Rates Below Firsts?

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September 9, 2002, Revised January 8, 2003

"Please settle an argument. My friend says that second mortgage rates today are below those on first mortgages. I say this is not possible because second mortgages are riskier to the lender than first mortgages. Who is right?"

You are right in the sense that on the same type of mortgage, on the same property, to the same borrower, and at the same time, the rate will be higher on the second. The reason is that in the event of default, the second mortgage lender gets repaid only if there is something left after the first lender is fully repaid. Second liens are riskier than first liens.

However, your friend is also right. If the second mortgage is a line of credit with an adjustable rate, it may well be priced below the rate on a first mortgage with a fixed-rate. The lower rate on the line carries greater risk for the borrower.

"I have a first mortgage on my house at 8% and am considering paying it off with a home equity loan at 5.75%. Would this be in my best interest?"

As a general rule, it is not a good idea to take out a second to pay off a first, because seconds are riskier than firsts and priced higher. If you take out a second mortgage to repay the first, the second becomes the first. This is a gift to the lender, since you are paying a second mortgage price on a first mortgage. In today’s market, you should be able to refinance your 8% loan into another fixed-rate loan at a significantly lower rate.

There is at least one exception to this rule. Borrowers with a high-rate first mortgage with a small balance may find it more advantageous to pay off the first with a second rather than refinance the first.

"I signed up for 2 mortgages, a first at 6.5% for 80% of property value, and a second for 10% of value. I can have the second at a fixed-rate of 7.49%, or at the prime rate, currently 4.75%, but adjustable. Which is better?"

Well, 4.75% is well below 7.49%, but it is also risky. Still, the risk could be one well worth taking. If it were me, I would take the adjustable at prime for 15 years, but I would make the payment that I would have had at a 7.49% rate. This will pay off the second mortgage early, reducing the risk of getting skinned if interest rates go up sharply.