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What Is a Second Mortgage and How Does It Work?

TLDR

What You Need To Know

  • A second mortgage is a loan you take out on your home if you’ve already got an existing mortgage
  • You can use a second mortgage to pay for home repairs, consolidate your debt or save money for your children's education
  • Taking a second mortgage has some great advantages, like being able to borrow money at a lower interest rate. But it’s risky if you can’t afford the second mortgage payment

Contents

A second mortgage is a loan you take out on your home if you’ve already got an existing mortgage. And if you are a homeowner in need of extra cash, there are two options you can consider.

The first is to refinance your home using the equity you’ve built since you got your first mortgage. If you can’t get the money you need from refinancing, a second mortgage may free up the funds you’ll need to accomplish your financial goals.

Getting a second mortgage has advantages and disadvantages. Whether it’s the right option for you depends on your financial situation. Read on to find out what a second mortgage is and if it’s the right option for you.

Second Mortgages, Explained

Your original mortgage is the mortgage you took out when you bought your home. Let’s say you bought your home for $150,000, and you’ve paid off $10,000 toward your mortgage principal. Now you owe $140,000. If your home appraises for $200,000, that’s a $60,000 gain in home equity.

A second mortgage lets you tap into your home equity and uses your home as collateral to secure the loan.

Refinancing vs. Second mortgages

So, what’s the difference between refinancing your mortgage and getting a second mortgage?

When you refinance your mortgage, your new lender pays off your original mortgage, and you stop making payments on it. Now you make payments on your new mortgage. Many homeowners refinance their mortgage to lower their interest rate, decrease their monthly payment or to change the terms of their loan.

When you take out a second mortgage, you aren’t swapping out your original mortgage for a new mortgage. You’re getting a mortgage in addition to your original mortgage, and you must continue to make the monthly mortgage payments on your original loan.

Second Mortgage Options

If you’re thinking about taking out a second mortgage, there are two types of second mortgages to consider: a home equity loan and a home equity line of credit (HELOC). There are a few differences between these loans. We’ll explore the benefits and drawbacks of both.

Home equity loans

Quick refresher: Home equity is the difference between the outstanding balance on your mortgage loan and the appraised value of your home. You use your equity to get approved for a home equity loan.

Home equity loans allow you to receive a single cash payment against the available equity in your home. You repay the loan every month at a fixed interest rate until the end of your repayment term.

If you know how much money you’ll need, this could be the better option because it allows you to lock in an interest rate.

Home equity line of credit

If you need more flexibility, consider a home equity line of credit (HELOC) instead.

A HELOC is similar to a home equity loan. You use your equity to access the money you need to achieve your goals, such as completing a home renovation. The difference is in how you access the money.

With a HELOC, you gain access to a line of credit for a predetermined amount of money you can draw on as needed. It works a lot like a credit card. There is a set maximum amount of money you can draw from (aka your credit limit) – but you don’t have to use the entire amount. Would you spend the entire credit limit on your credit cards? You borrow what you need and only pay interest on what you borrow.

You can only borrow from a HELOC during its first phase: the draw period. Once the draw period is over, you pay your balance off in monthly installments until your balance hits zero.

Common Uses for a Second Mortgage

There’s no limit to what you can use a second mortgage for. If you need to borrow money, a second mortgage can give you access to funds at a low interest rate because the loan is secured by your home. Homeowners commonly use second mortgages to:

  • Consolidate credit card debt at a lower interest rate
  • Access money at a lower interest rate than a personal loan or credit card
  • Renovate or make repairs on their homes
  • Pay for a child’s college education
  • Gain access to a revolving line of credit with a higher credit limit than traditional credit cards
  • Make a down payment on an investment property or rental property

Second Mortgage Requirements

There are several things you’ll need to qualify for a second mortgage.

Equity in your home

Lenders usually require that you maintain around 75% – 80% equity in your home before you can qualify for a second mortgage.

If your home’s appraised value is $200,000, you’d only be able to borrow against your equity if there is more than $150,000 – $160,000 available in equity to qualify for a second mortgage.

If the amount of equity you have in your home doesn’t meet a lender’s requirements, you could be denied a second mortgage loan.

A good credit score

Your credit score is a three-digit number between 300 – 850 that measures your creditworthiness. Most lenders prefer borrowers with credit scores in the mid-600s or higher. You can get a loan with a lower credit score, but your score will affect the loan’s interest rate and the amount of money you can borrow. 

Debt-to-income (DTI) ratio

Your DTI takes your fixed monthly expenses and divides them by your gross monthly income. Lenders review your DTI to determine if you can afford to pay your monthly loan payments and your other debts. If your DTI is higher than 43%, the lender may not approve your loan.

You can check your DTI with our easy-to-use calculator.

Financial documents

Lenders will require bank statements, proof of income, tax returns and other financial documents before they can underwrite your loan. All the information is used to determine your eligibility.

Things to Consider

If you’re shopping for a second loan, review your options carefully. Just because you’re approved for a loan doesn’t mean the loan aligns with your goals, needs – or wallet.

Here are some of the most important things to review when you’re looking for a second mortgage:

Second mortgage rates

You can usually get a better interest rate on a second mortgage than if you tried to get other types of loans. Because of the low interest rates on second mortgages, many homeowners use them to consolidate their credit card debt, rolling their high-interest debt into a low-interest loan.

If interest rates are high or your credit score is on the lower end, the “low interest advantage” may diminish.

Borrowing limits

Consider how much money you’re able to borrow when reviewing the terms of a second mortgage. Your credit score, your income, how much equity you have in your home and your DTI all impact borrowing limits.

Approval time

The amount of time it takes to complete the loan approval process may vary based on the lender. Typically, it can take 4 – 6 weeks. So, don’t make any plans until you know when you’re going to receive funding.

Closing costs and fees

Many people overlook the cost of closing on a second mortgage, which can range from 2% – 5% of the loan’s value. When you’re doing your financial planning, keep this in mind so you can plan ahead. You should also consider how those closing costs may affect your ability to repay the loan.

Risk of foreclosure

It’s important to ensure that you can afford the monthly payments on the second mortgage. If you default on your home equity loan or HELOC, the lender can foreclose on your home.

Losing a home through foreclosure is a difficult experience. To keep your home, you’ll need to make a lump-sum payment and pay legal fees to your lender.

What Are the Advantages of a Second Mortgage?

There are plenty of reasons why a second mortgage may be the right choice for you.

The interest you pay on the loan can be deducted from your taxes each year, which is the same benefit you get with your original mortgage. You can, essentially, cash in on the equity you’re building in your home.

If you need to spend money on big-ticket items, it can give you the financing you need at a lower interest rate than if you used credit cards or took out a personal loan.

What Are the Disadvantages of a Second Mortgage?

Second mortgages aren’t for everyone. You must have enough home equity to qualify for the loan. You’ll also have to take closing costs into account. Depending on the home’s value, the closing costs (which can be paid upfront or rolled into the second mortgage) could cost up to tens of thousands of dollars.

Also, taking a second mortgage out can be risky. If you can’t afford the second mortgage payment, you could lose your home.

Should You Get a Second Mortgage?

You might be a good candidate for a second mortgage if you have a lot of equity in your home and believe you can make the additional mortgage payments.

What’s most important is that you review all of your options before making a decision that could impact you for a long time. There are other options if you need a loan to cover home repairs, your kid’s college education or to consolidate your debt.

Think about what’s changed since you took out your first mortgage. Has your income or credit score changed for the better? Did your house gain in value? If you can confidently answer “yes” to these questions, you could qualify for the second mortgage.

If your project or goal isn’t time sensitive, you may want to consider saving money instead of borrowing and paying interest on what you borrowed. If it can’t wait and you know you can afford the loan, getting a second mortgage might be a savvy money move.

No More Second Guessing

A second mortgage can solve a lot of problems by giving you the money you need to achieve your financial goals. You can perform repairs to your home, use the money to pay off your credit cards or pay for your child’s college tuition. Before you decide to apply for a loan, keep in mind how the loan will affect your financial health.

  1. Internal Revenue Service. “Tax reform affects if and how taxpayers itemize their deductions.” Retrieved March 2022 from https://www.irs.gov/newsroom/tax-reform-affects-if-and-how-taxpayers-itemize-their-deductions

ICYMI

In Case You Missed It

  1. A second mortgage is different from refinancing. With a second mortgage, you continue to make payments on your first mortgage

  2. There are two types of second mortgage loans: a home equity loan and a HELOC. Choose the one that fits your needs and your budget

  3. Many people take out a second mortgage because personal loans typically have lower borrowing limits and higher interest rates

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