Loan Provider Advice on Second Mortgages Is Suspect

September 17, 2007

Borrowers selecting between a second mortgage and a cash-out refinance should not rely on the judgment of mortgage brokers or loan officers in making the decision because they make much more money on a cash-out refinance.

"My house is worth $400,000, the balance of my 5.5% first mortgage is $270,000, and I need $50,000 to pay off debts and make some improvements. I spoke to 3 mortgage brokers, and all advised me to refinance my first mortgage for about $325,000. I was thinking that I would just take a second mortgage for $50,000, but the brokers all rejected that idea. What am I missing here?"

What you are missing is a realization that, in selecting between a cash-out refinance and a second mortgage, the broker’s interest and yours may be in conflict. A mortgage broker might pocket a fee of $3,000 or more on a $325,000 cash-out refinance, but only $500 or even less on a $50,000 second mortgage.

Borrowers who need cash should select the option that is least costly over the period they expect to be in their house. My calculator 3d -- Mortgage Refinance Calculator: Cash-Out Refi Versus Second Mortgage -- pulls together all the factors that determine whether a second mortgage or a cash-out refinance will cost less. The most important of these factors is the interest rate on the cash-out refinance, relative to the rate on the existing mortgage. If the new rate is higher, which is likely to be the case today, the second mortgage probably will cost less.

The upshot is that borrowers should not rely on the judgment of loan providers in making decisions about a cash-out refinance. This applies not only to mortgage brokers, but to loan officers employed by lenders. Loan officers are compensated by commission which is calculated as a percent of the loan amount. They have the same financial incentive as mortgage brokers to steer a customer to a cash-out refinance rather than a second mortgage. 

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