Second Mortgage vs Refinance: Which is better for Canadians?

For Canadian homeowners, leveraging the equity in their property is often necessary to access funds for renovations, debt consolidation, education costs, or other major expenses. Two of the most common ways to take out home equity are second mortgages and refinancing. But how do you know which option is better for your financial situation?

This guide will compare the key differences between second mortgage vs refinance in Canada. With the right information, you can decide whether to take out a second mortgage or refinance your home.

Understanding Second Mortgage and Mortgage Refinance

A second mortgage refers to any additional loan against the equity on a property with an existing first mortgage. It is considered second because it has lower priority than the original mortgage in the event of default.

Mortgage refinance involves replacing your current mortgage with a new mortgage, allowing you to change the amount borrowed, interest rate, term length, and other factors.

5 top reasons homeowners choose to refinance in Canada include:

• Lower interest rate – Reduce monthly payments by securing a new lower rate
• Access equity – Cash out built-up home equity
• Consolidate debts – Combine high-interest debts into the mortgage
• Switch mortgage types – Move from a variable to a fixed interest rate
• Change the amortization period – Extend the length of the mortgage

What are the differences between Second Mortgage and Refinancing?

When weighing the pros and cons of a second mortgage vs refinancing, there are 7 key differences to consider:

Number of Loans

With a second mortgage, you end up with two separate mortgages and two monthly payments – one for the original first mortgage and another for the second mortgage. This can make budgeting and tracking your mortgage obligations more complicated.

On the other hand, when you refinance, you consolidate your mortgages into one new mortgage, meaning just one monthly payment to one lender. This simplifies your mortgage payments into a single, predictable amount each month.

Interest Rates

Second mortgages usually have higher interest rates than first mortgages or refinancing options. Given their second lien position, lenders view second mortgages as higher risk. If the borrower defaults, the second mortgage is only repaid after the first mortgage is paid in full.

For example, current rates for a 5-year fixed second mortgage are 6-8%, compared to 3-5% for a first mortgage or refinance. This 2-3% interest rate gap is substantial and can add up over a mortgage.

With refinancing, borrowers with good credit usually obtain significantly lower rates, thereby reducing interest costs over the long run.

Maximum Loan-to-Value Ratio

Second mortgages sometimes allow borrowers to borrow up to 95% of a home’s value. This is because they are primarily assessed based on the home’s available equity.

On the other hand, when refinancing conventional mortgages, lenders usually cap the maximum loan-to-value ratio at 80%. This LTV cap aims to mitigate lenders’ risk by ensuring the borrower has at least 20% equity remaining in the home after the new mortgage.

For example, say a home is currently worth $200,000. With 20% equity of $40,000, the maximum on a refinance would be $160,000 (80% LTV). However, a second mortgage could reach $190,000 (95% LTV) since it focuses more on equity than the home’s market value.

Those who have built up equity over many years but still owe a substantial first mortgage can utilize a second mortgage to tap more of their available equity.

Eligibility Requirements

Second mortgages generally base their approval decisions primarily on the amount of equity available, without too much emphasis on the borrower’s income or credit scores. This provides an advantage to those with a challenged financial or credit profile but who need to access their equity.

In contrast, refinancing involves thoroughly examining the borrower’s financial standing, including factors like employment income, other debts and expenses, and credit history. Most lenders require a minimum credit score of around 680 for refinancing approval.

So, those with credit scores below 680 may struggle to qualify for refinancing but could still potentially be approved for a second mortgage leveraging their equity. Accessing equity is less contingent on employment, credit, and GDS & TDS ratio.

Term Length

Second mortgages typically offer much shorter mortgage terms than refinancing. Common terms are 1-5 years, with an average of 2-3 years.

When refinancing, borrowers can significantly extend their amortization, even up to 30 years, for a new mortgage. This longer repayment timeline can be advantageous for keeping monthly payments affordable.

Shorter terms do benefit second mortgages by forcing discipline. Borrowers must repay the funds within a few years rather than decades. However, stretched-out payments through refinancing can make the monthly amounts more manageable.

Tax Implications

Interest paid on second mortgages or home equity lines of credit is not tax deductible unless the borrowed funds are used explicitly for home improvements or renovations. In this case, up to $10,000 in interest may be deductible annually.

Understanding potential deductibility is essential when refinancing. As noted above, some of the interest may qualify as a deduction if it is used to fund renovations. However, the interest would not be deductible for other purposes, like consolidating debts.

So, those planning to use the borrowed funds for renovations should note the potential tax benefits if the loan is arranged as a refinance rather than a second mortgage.

Upfront and Ongoing Costs

Refinancing requires closing costs and legal fees, typically 2% to 6% of the loan amount. Second mortgages may have lower upfront costs. [Source]

For example, 3% closing costs on a $300,000 refinance would be $9,000, compared to $1,500 for a $50,000 second mortgage.

Refinancing allows you to secure a much lower rate on the entire mortgage balance, potentially saving thousands in interest annually. Based on the above example, reducing the rate by 1% on the refinanced $300,000 balance would save $3,000 annually.

In summary, carefully examining all these parameters – number of loans, interest rates, LTV, qualification criteria, terms, and taxes – is crucial when deciding between a second mortgage and refinance.

Factor	Refinancing	Second Mortgage
Interest Rate	Usually lower rate	Higher rate than first mortgage
Closing Costs	Higher upfront costs	Lower upfront costs
Debt Consolidation	Consolidates into new first mortgage	Debts remain separate
Monthly Payments	Increases main mortgage payment	Adds separate extra payment
Prepayment Penalties	May incur penalties	Avoids prepayment penalties
First Mortgage Terms	Cancels first mortgage	Leaves first mortgage intact

How to Calculate Combined Interest Rates?

When determining whether a second mortgage or refinance is more cost-effective, you can calculate the combined interest rate using a mortgage averaging calculation.

The formula is:

(1st Mortgage Balance x Interest Rate) + (2nd Mortgage Balance x Interest Rate)
Divided by Total Mortgage Balance

Let’s look at an example:

You currently have a $300,000 first mortgage at 3% interest. You are debating between:

Option 1: Refinancing to $330,000 at 4%

Option 2: Taking a $30,000 second mortgage at 12%

Using the formula:

Option 1 Refinancing Rate = 4% (single new mortgage)

Option 2 Second Mortgage:
($300,000 x 3%) + ($30,000 x 12%) = $9,000 + $3,600 = $12,600
$330,000

Combined Rate = 3.82%

In this scenario, the second mortgage has a lower average interest rate than refinancing, making it more cost-effective.

When to Consider a Second Mortgage over Refinancing?

In certain situations, a second mortgage can be the more optimal choice:

• You need access to funds quickly without refinancing the first mortgage. The second mortgage can be arranged faster.
• You have sufficient home equity, but challenged credit or income makes refinancing difficult.
• You want to keep the current rate and terms of the existing first mortgage.
• You only need a relatively small cash relative to your total mortgage balance. The second mortgage allows you to access the funds without refinancing the large first mortgage.
• You plan to repay the second mortgage much sooner than the first mortgage term, so shorter second mortgage terms may be beneficial.

When Refinancing May Be the Better Option?

In other cases, refinancing into a single new mortgage tends to make more sense:

• You want to consolidate high-interest debts into your lower-interest mortgage.
• Your current mortgage rate is much higher than available refinancing rates, so you can save significantly through refinancing.
• You need to access much home equity, which is closer to 80% LTV.
• Your credit score and income have improved since you obtained your original mortgage, so you may now qualify for better refinancing terms.
• You are willing to go through the full application process and feel the benefits outweigh the closing costs.
• You want to modify the mortgage structure, like switching from variable to fixed rates.

Second Mortgage vs Refinance: Choosing the Right Option for You

Tapping into your home equity can provide funds for important objectives like debt consolidation, home renovations, and upgrades. A second mortgage and refinancing allow you to access equity differently.

Here are 5 key questions to ask yourself when deciding:

• How much equity do I need to access in the near term?
• What are my credit score, income, and debt levels?
• How much can I afford in total monthly mortgage payments?
• How soon do I need to access funds?
• Do I want to preserve my current mortgage terms and rate?
• What are the total all-in costs for each option?

Second mortgage and refinancing have pros, cons, costs, and qualifications. Your financial situation will determine which option makes the most sense.

There is no definitively superior option! Carefully compare interest rates, terms, qualification criteria, costs, tax implications, and your financial profile. This will lead you to the best mortgage decision for your property, budget, credit, and goals.

Let the mortgage brokers at Best Mortgage Onlineshop the market for your best rates, terms, and costs to ensure you make the most financially advantageous decision.

FAQs

Article Sources

1. Comparing a Second Mortgage vs Refinance
2. How to choose between a refinance, a HELOC and a second mortgage