What is a First Mortgage?
JA
Summary:
A first mortgage is the primary loan that a homebuyer uses to purchase a property. It’s also called a primary lien because if the borrower defaults, it has priority over all other claims on the property.
Financing a home is one of the biggest financial decisions you’ll make in life, so it’s important to understand all of the details before signing any contracts. When you’ve decided on a property, you’ll most likely have to take out a first mortgage loan.
A first mortgage is a primary loan taken out on any property, not necessarily the loan taken out to purchase the borrower’s first home. In this post, we’ll break down what you need to know about first mortgages, how they work, and how they differ from second mortgages.
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How does a first mortgage work?
A first mortgage is a type of secured loan used to finance the purchase of a home. Because it’s secured by your property, if you default on the mortgage the lender has the right to recoup their losses by taking back possession of the house through foreclosure.
When you take out a first mortgage, you generally have to choose between a fixed interest rate or an adjustable interest rate. Fixed-rate mortgages have an interest rate that remains the same for the life of the loan, while adjustable-rate mortgages have an interest rate that can change over time based on the market.
Each month, a portion of your monthly mortgage payments will go toward paying off the interest, and the rest will go toward paying the principal. For most types of homes, first mortgage loans’ terms are typically 15, 20, or 30 years.
Why is a first mortgage the top priority?
How does a first mortgage work in terms of its priority over other mortgage loan types? To help you better understand, here’s a quick example:
Let’s say Amanda secures a $250,000 first mortgage loan on a property. After a few years, she manages to pay her mortgage down to $180,000. Eager to remodel her home, she then decides to take out a $40,000 home equity loan (a type of second mortgage) to finance the project.
Due to some personal circumstances, Amanda defaults on her payments, and her home is foreclosed and sold for $215,000. In this case, since first mortgages are senior to second mortgages, the first mortgage lender will first receive the $180,000 that Amanda still owes. The second mortgage lender will then receive what’s left—in this case, $35,000—$5,000 short of what’s owed.
Because of the order in which you took out the loans, first mortgages are repaid first. With this risk in mind, second mortgage lenders usually charge higher interest rates compared to first mortgage lenders.
What happens to a first mortgage if you refinance?
If you’re hoping to reduce your mortgage debt, you may have looked into refinancing your home loan. When you refinance a mortgage, you essentially replace your old loan with a new one. Since you aren’t getting another mortgage and just replacing your old one, the refinanced mortgage becomes the new first mortgage.
Refinancing can be a useful option for most homeowners, but only with the right research. In order to get the best loan terms, it’s best to consider multiple mortgage refinancing lenders.
First mortgage requirements
The requirements of a first mortgage can change depending on whether you’re applying for a government-backed loan or a conventional loan.
Government-backed loans such as VA, USDA, and FHA loans typically have more lenient borrower requirements and are designed to help more people afford homes. On the other hand, since conventional loans are not insured or guaranteed by a government entity, to lower the risk of default they generally require a higher minimum down payment and credit score.
Loan-to-value ratio
A loan-to-value (LTV) ratio is a term in the mortgage industry that describes the size of a mortgage in relation to the value of the property. It’s a key risk factor that lenders assess before qualifying you for a mortgage.
In general, if the LTV of your first mortgage is greater than 80%, lenders will require that you pay private mortgage insurance to protect them in the event of default. An LTV ratio of 80% means that for every $100,000 worth of a house, you have an $80,000 mortgage.
Pro Tip
Make sure to itemize expenses on your tax return, including anything you pay in mortgage interest on your first mortgage, as this interest could be tax-deductible.
First mortgage vs. second mortgage
Both a first and second mortgage are secured loans that use a property as collateral. Beyond that, however, the two loans have several key differences to highlight.
| First mortgage | Second mortgage |
|---|---|
| Primary lien, repaid before other loans | Second lien, repaid after other loans are repaid |
| Choose between fixed and variable interest rates | Choose between fixed interest (home equity loans) and variable interest rates (HELOCs) |
| Often used to finance home purchase price | Often used to finance renovations and home repairs or to consolidate debt |
| Loan limits determined by borrower’s credit history and down payment | Loan limits determined by the amount of equity in the home |
| May require PMI depending on size of down payment | Doesn’t usually require PMI, but may affect PMI on first mortgage |
Pro Tip
To qualify for a second mortgage, apart from meeting basic borrower requirements, you also need to have at least 15% to 20% equity in your property.
To calculate your home equity percentage, start by subtracting your mortgage balance from your home’s current market value, then divide that number by the market value. If the value of your home is $400,000 and you still owe $250,000 on your mortgage, your home equity percentage would be 37.5%.
FAQs
What is a first mortgage lender?
A first mortgage lender is simply the financial institution that you go to for your primary mortgage on a property. First mortgage lenders can be a bank, credit union, or even online lender.
What is a lien on a property?
A mortgage lien is a legal claim against a property that secures the payment of a debt. When you take out a mortgage to buy a home, the lender essentially files a lien against your property to ensure that the debt will be paid back. If you fail to make payments on your mortgage, the lender can then foreclose on the property, and sell it to recover its losses.
What does it mean to take out a second mortgage?
When you take out a second loan, you borrow against the equity in your home when you still have your first mortgage. It can be a great financing option if you need cash quickly and don’t want to sell your house. However, this also means you’ll be responsible for making monthly payments on both your first and second mortgages.
Is taking out a second mortgage a good idea?
Second mortgages can be a great way to help you get the money you need for home improvements, debt consolidation, or investing without selling your property. But there are also some potential downsides to taking out a second loan. For example, it’ll likely increase your monthly mortgage payments, and even increase the risk of you defaulting on the loan.
Just be sure to do your homework beforehand. Shop around for the best interest rates and terms, and make sure you understand all the fees and charges involved. Most importantly, only borrow as much as you need.
Key Takeaways
- A first mortgage is a primary loan that a homebuyer borrows to purchase a home. It’s also referred to as the primary lien in the event of default because it has priority over other claims on the property.
- If the loan-to-value ratio of a first mortgage is higher than 80%, mortgage lenders will require borrowers to pay private mortgage insurance (PMI) due to the higher default risk.
- A second mortgage is a loan that a homeowner takes out using the equity in their home. It’s often used to finance things like home improvements, education, investments, or debt consolidation.
- Before taking out a second mortgage loan, it’s important to assess your financial situation. Remember, even if a second loan can provide some short-term relief, it’ll eventually need to be paid back with interest. If you think you’ll struggle to make your mortgage payments, it’s best to avoid taking on more debt.
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