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What is a second mortgage?

A second mortgage is a home equity loan or home equity line of credit (HELOC) that uses the borrower’s home as collateral. It’s called a “second mortgage” because the borrower’s first mortgage, the loan obtained to buy the house, is also secured by a lien on the home.

Why take out a second mortgage?

A second mortgage allows a homeowner to borrow against his or her home equity. Homeowners usually take out second mortgages to pay for big-ticket expenses such as:

  • Home improvements.
  • Medical bills.
  • College education for a child.
  • Consolidation of higher-interest debt, such as credit cards.

Some borrowers use second mortgages to buy investment property. This can be risky since a downturn in the housing market may hurt the value of both properties.

Getting a second mortgage to buy a car or to pay for a vacation or other luxuries isn’t advisable. Your home is on the line, so any expense that will not add to the value of your home or the earning power of your household should be considered very carefully.

Types of second mortgages

Home equity loan: A home equity loan is a one-time lump sum that is repaid at a fixed interest rate. These loans are usually 15- to 30-year loans and are similar to a conventional purchase mortgage.

HELOC: A home equity line of credit, or HELOC, is similar to a credit card. It carries a variable interest rate, and as the borrower repays the principal, the credit line revolves and can be used again. HELOCs have a draw period, during which the borrower can withdraw the money and pays only interest each month. There’s also a repayment period, during which the borrower pays both principal and interest. Monthly payments rise significantly during this phase.

Advantages of a second mortgage

  • A second mortgage is a way to borrow a significant amount of money — more than you could get without using your home as collateral. How much equity you can tap depends on your debt level, income, credit history and other factors.
  • Interest rates on second mortgages are lower than rates on credit cards or personal loans because your home backs the loan, reducing the risk for the lender.
  • If you use a second mortgage “to buy, build or substantially improve the taxpayer’s home that secures the loan,” the interest is tax-deductible.

Disadvantages of a second mortgage

  • Risk of foreclosure is a possibility with any loan secured by a home. If you quit making your mortgage payments, the lender can foreclose on your home. That’s why frivolous spending of home equity money is dangerous.
  • A second mortgage can be a hindrance if you want to refinance, need a loan modification or have to sell your home in a short sale.
  • Closing costs on second mortgages can be expensive, often thousands of dollars. Expect to pay for origination fees, title fees, the appraisal and a host of other costs. However, many of these costs are negotiable.
  • The new federal tax law limits deductibility of interest on home equity loans and HELOCs. If you use a second mortgage to pay off credit card debt or a student loan, for example, the interest is not deductible.

Tips for getting a second mortgage

Have a plan. Before you approach a lender, know how much you need to borrow and how long you need it for. This will help you decide whether a straight home equity loan or a HELOC will serve you better. If you want to consolidate debt, a lump-sum equity loan might be better. If you are renovating your home over a number of years, the HELOC makes more sense.

Check your credit score and credit report before applying for a loan. Correct any mistakes in your credit report, and if your credit score is sagging, take steps to improve it, such as by paying down debt.

Gather all your paperwork. Lenders will want pay stubs, tax returns, bank statements and more. You can streamline the process by collecting documents that show your income and assets.

Shop around. A local bank or credit union is a good place to start. Get quotes from several lenders, including online lenders, and compare them. Never go with the first lender who’s willing to give you a loan. Check out today’s home equity rates at Bankrate.com.

Use Bankrate’s home equity calculators to help you determine how much you can borrow and how long it will take to pay it off.