Could your second mortgage ruin your refinance?
Second mortgages can create difficulties when you refinance. By subordinating your second mortgage to your new first mortgage, these challenges can be overcome.
When might your second mortgage pose refinancing problems?
Ideally, you replace your first and second mortgage with a new first mortgage when you refinance. That generally gets you the lowest mortgage rates. But you might not always want or be able to do that. For example:
- Your home equity loan or line of credit (HELOC) might have an ugly prepayment penalty.
- You may prefer to keep a HELOC open for business purposes or other reasons.
- Your new first mortgage would have to have mortgage insurance (if you have less than 20 percent home equity).
You can resolve these issues by keeping your second mortgage and subordinating it to your new first mortgage.
What is mortgage subordination?
Here's how mortgage subordination works, and why it's required:
Home equity loans and HELOCs are often called second mortgages because their lien holders are in second position, behind the lien holders of the first mortgage. This means that should you default on your home loan and end up in foreclosure, the first lien mortgage lender is paid from the proceeds of the foreclosure sale before anyone else. Other lenders are called "junior lien holders" and are repaid only after the first mortgage lender's claim is fully satisfied. Often, there is no money left to repay junior liens. So home equity lenders take a riskier position, which explains why these loans don't carry the best mortgage rates.
If you refinance your first mortgage but not your second mortgage, the second mortgage is promoted into first position (because it's older than the new first mortgage), and the newly refinanced mortgage takes the junior position. Your new lender will obviously object, and will not fund your refinance loan unless the second mortgage lender agrees to move itself back into the junior position. That process is taken care of in escrow and is called subordination.
How do you get a second mortgage subordination?
Junior lien holders don't just automatically agree to drop their loan behind a new first mortgage. Here are some typical requirements:
- You must be current on your mortgage payments and in good standing with your lender.
- Your new mortgage payments can't increase beyond specified limits (you might be able to get around this if your income has increased so that your debt-to-income ratios are the same or better).
- You can't usually consolidate debt or take cash out with your new first mortgage (although you may be able to make the argument that debt consolidation makes you a better risk).
- You may have to pay administrative charges, usually not prohibitive.
You may be able to get the lender to make an exception and waive its policy if you can demonstrate that the new loan strengthens your financial position and therefore lowers the lender's risk (if, for example, debt consolidation decreases your debt-to-income ratio from 51 percent to 36 percent), or if you can show that your profile is exceptionally strong (great credit, excellent income, low credit usage and plenty of assets). Expect getting an exception to take some time; you should ideally resolve the subordination issues before applying for a mortgage refinance.
What if a lender refuses to subordinate your loan?
It can happen, even when it makes no sense. Some lenders are just frustrating to deal with. The best thing to do when getting a second mortgage is to obtain the lender's written subordination policy before you close your loan so it doesn't become an issue down the road. There is no good reason that a junior lien holder should refuse to subordinate a home equity loan if you are in good standing and the newly refinanced mortgage doesn't increase its risk.
However, it still may not matter. If that's the case, make the lender understand that it will lose your business if it doesn't abide by your reasonable request. If the lender still won't help, get some second mortgage quotes and refinance with a more cooperative lender. Refinancing a home equity loan costs very little and doesn't take long. Get the new lender's subordination policy in writing (now you know to always do this, right?) and make sure it will subordinate its lien to that of your new first mortgage lender.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.