A second mortgage is a loan that uses the equity in the borrower’s home as collateral. It’s called a second mortgage because it follows the first mortgage, obtained to buy the home. Both types of mortgages are secured by liens on the property. Common examples of second mortgages include home equity loans or home equity lines of credit (HELOCs).
How does a second mortgage work?
A second mortgage is a type of loan that lets you borrow against the equity in your home. Equity is the value of your home above the remaining balance you owe on your first mortgage. So, if your home is valued at $300,000 and you still owe $200,000 on your first mortgage, you have $100,000 worth of equity in the house.
You can use funds from a second mortgage for a variety of purposes. Some of the most common uses of second mortgages include consolidating other debts (especially high-interest credit cards) and financing home improvements or repairs.
To qualify for a second mortgage, you must first have enough equity in your home to satisfy a lender. Equity requirements vary, but some lenders may let you borrow up to 85 percent of your home’s value if you can meet other qualification standards (i.e., debt-to-income ratio, credit score requirements, etc.).
In the example above with $100,000 in equity on a $300,000 home, you might be able to borrow as much as $85,000 through a second mortgage. The second mortgage would bring your total mortgage debt up to $285,000.
Types of second mortgages
People who wish to take out a second mortgage usually choose between home equity loans or home equity lines of credit. Here’s a look at each of these financing options.
Home equity loan
A home equity loan is financing you receive in a one-time lump sum. You secure the loan with the equity in your home and repay the loan at a fixed interest rate, meaning your payment will remain the same every month.
Repayment terms for home equity loans frequently range between five and 30 years. If you don’t repay the loan as agreed, the lender can foreclose on your home to try to recuperate its losses.
Home equity line of credit (HELOC)
Home equity lines of credit are similar to credit cards but secured with your home equity. You borrow money and, as you repay it, you can use the credit line to borrow again — up to your credit limit. Like credit cards, interest rates on HELOCs are also variable.
HELOCs have a draw period, often up to 10 years. During the draw period you can withdraw funds as you need them and may only be required to pay interest (depending on the financing terms).
There’s also a repayment phase with HELOCs — sometimes as long as 20 years. During the repayment phase you must pay both principal and interest. Monthly payments can rise significantly during this period. Again, if you don’t pay as promised, the lender may foreclose on your property.
When to get a second mortgage
A second mortgage allows a homeowner to borrow against their home equity. Homeowners usually take out second mortgages to pay for items such as:
- Home improvements.
- Medical bills.
- A 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, as a downturn in the housing market could lower the value of both properties.
Getting a second mortgage to buy a car, pay for a vacation or purchase other luxuries isn’t advisable. After all, your home is on the line; any expense that will not add to the value of your home or the earning power of your household should be considered carefully.
What to consider when getting a second mortgage
Before you take out a second mortgage, it’s important to consider the risks. You should also weigh the pros and cons to make sure this type of financing will work well for your situation.
Advantages of a second mortgage
- A second mortgage may help you borrow a significant amount of money — more than you could typically 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 generally lower than rates on credit cards or personal loans. Because your home backs the loan, you reduce the risk for the lender. This lender risk reduction can translate into savings for you as a borrower.
- If you use a second mortgage to buy, build or substantially improve the home you use to secure the loan, the interest may be tax deductible.
Disadvantages of a second mortgage
- Risk of foreclosure is a possibility with any loan secured by a home. If you stop making your mortgage payments, the lender can foreclose on your home. That’s why frivolous spending of home equity money can be dangerous.
- A second mortgage may be a hindrance if you want to refinance, need a loan modification or have to sell your home quickly.
- Closing costs on second mortgages can be expensive, often adding up to thousands of dollars. Expect to pay for origination fees, title fees, the appraisal and a host of other expenses. However, many of these costs are negotiable.
- 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
If you’ve weighed the pros and cons of a home equity loan or HELOC and are ready to move forward, start with the following steps:
- Make sure you have equity in the home. Lenders won’t extend credit against a property that has little owner’s equity. Generally, the homeowner must have at least 20 percent equity in their home, meaning their remaining mortgage makes up no more than 80 percent of the home’s total value. You can check this number by dividing your remaining mortgage balance by your home’s value. If you have a $300,000 home and $250,000 remaining in mortgage payments, you have an 83 percent loan-to-value ratio and 17 percent equity.
- Have a plan. Before you approach a lender, know how much you need to borrow and whether you need a one-time loan or the option to borrow multiple times. 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 might make more sense.
- Check your credit scores and reports before applying for a loan. It’s smart to check all three of your credit reports and scores before you apply for any type of financing. Dispute any credit-reporting mistakes you discover. If your credit score is sagging, take steps to try to improve it. Paying down credit card debt is often a great place to start.
- Gather all of your paperwork. Lenders will want pay stubs, tax returns, bank statements and more. You can streamline the process by compiling all documents that show your income and assets before you apply for financing.
- 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 that’s willing to give you a loan.
Are second mortgage rates higher than first mortgage rates?
In general, interest rates on second mortgages are higher than the interest rates you can find for first mortgages. This is because lenders that issue second mortgages are taking a bigger risk.
When you qualify for a second mortgage, the lender places a new lien against the property when it gives you the loan. With a lien in place, the lender has a right to take the proceeds from the sale of your home in the event of a foreclosure.
Should you sell your home or face foreclosure before you pay off your mortgages, the lender that holds the first mortgage lien is paid first. Second mortgage liens are usually next in line. So if there’s a shortage of cash, the second mortgage might not be completely satisfied from the sale of the property.
If you need to borrow a large sum of money or you want to secure financing at a lower interest rate, a second mortgage may be worth considering. However, you should reserve this type of financing to pay for projects that will boost the value of your home or your overall earning power and net worth.
Before you borrow, be sure to check out rates from multiple lenders. You can check out today’s home equity rates at Bankrate.com.
It’s also wise to examine your personal finances before you take on any new debt. Use Bankrate’s home equity calculators to help determine how much you can borrow and how long it will take to pay it off.
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