A homeowner can use a second mortgage as a way to tap into home equity without selling the house. Although the bank may use different names for the types of offered equity loans, a closed-end second offers lower costs and certainty compared to the more flexible open-end type of second lien real estate loan.
Home Equity Types
Loans that are backed by equity in the home that is above the balance of the first mortgage fall into the two categories of either a home equity loan or home equity line of credit. A home equity loan is classified as a closed-end second mortgage, and in contrast, a HELOC would be an open-end loan. With the closed-end loan, the borrower receives the lump sum amount of the loan when the paperwork is completed. With a HELOC the homeowner can take money at any time up until he has drawn out the full amount approved for the loan.
One-Time Receipt of Money
With a closed-end second mortgage loan, the payment of the loan amount is a one-time disbursement to the homeowner from the bank. When the loan is paid off, the homeowner cannot again get money from that same loan. The fact of a single payment of the loan amount to the homeowner is what classifies the loan as closed-end. In comparison, with an open-end line of credit, the homeowner can pay down the loan balance and then draw the money out again to increase the outstanding loan amount.
Closed-End Loan Features
A closed-end home equity loan will function in the same manner as other fixed-amount, fixed-term loans. The homeowner gets the loan amount at the start and then makes regular monthly payments to pay off the loan over a set number of payments, such as 10 years or 120 payments. The interest rate can be either fixed or variable, depending on what the bank offers and the choices made by the homeowner. A closed-end second mortgage makes sense if the homeowner has a current use for the money and likes the idea of regular monthly payments to pay back the loan.
Costs vs. Flexibility
In exchange for flexibility when the money is actually borrowed, the up-front costs, ongoing fees and possibly the interest rate for an open-end line of credit will be higher than the overall borrowing costs associated with a closed-end home equity loan. A closed-end loan restricts borrowers to a one-time payment of the amount borrowed, but this type of loan will be the low-cost option to borrow against a homeowner's home equity. The closed-end equity loan allows a borrower to stick with a fixed interest rate, which may provide additional peace of mind.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.