What is a second mortgage, and how does it work?
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The cost to buy a home in the U.S. has skyrocketed since early 2020, reaching record highs. Though prices have cooled a bit recently, many homeowners still have significant equity in their homes as a result of the runup. In fact, in 2022, the average U.S. homeowner gained approximately $14,300 in home equity, according to CoreLogic.
One of the ways homeowners can tap their equity for ready money is by taking out a second mortgage — so-called because it uses your home as collateral for the debt. Common examples include a home equity loan and a home equity line of credit (HELOC).
- A second mortgage is a type of subordinate mortgage taken out while the original, or first, mortgage is still being repaid.
- Like the first mortgage, the second mortgage is secured by a lien on your property.
- A home equity loan and a home equity line of credit (HELOC) are two common types of secondary mortgages.
- You have to have built up a certain amount of equity (outright ownership stake) in your home to borrow against it, and you must maintain a minimum amount of equity in the home.
What is a second mortgage?
When you take a second mortgage, you borrow from the equity you’ve built up in your home — in other words, the difference between the value of your home and the remaining balance on your first mortgage. Homeowners typically access equity by taking a home equity loan or a home equity line of credit (HELOC).
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 card balances) and financing home improvements or repairs.
How does a second mortgage work?
To obtain a second mortgage, you typically need to do the same things you did to qualify for a primary mortgage. The process includes submitting an application to a lender and providing documentation regarding your income, debts and assets. You might also need to get an appraisal to confirm the current value of your home.
Equity requirements vary, but many lenders prefer that you have at least 15 percent to 20 percent equity in your home. You can typically borrow up to 85 percent of your home’s value, minus your current mortgage debts. If you have a home worth $300,000 and $200,000 remaining on your mortgage, for instance, you might be able to borrow as much as $55,000 through a second mortgage: ($300,000 x 0.85) – $200,000.
Requirements for applying for a second mortgage
- At least 15 percent to 20 percent equity in your home
- Remaining mortgage has to be less than 85 percent of the home’s value
- A credit score of 600 or higher (recommended)
What are the pros and cons of getting a second mortgage?
Second mortgages can be helpful in a variety of situations, but they do have drawbacks that you need to consider.
- Access your equity. Their home is one of the most valuable assets most Americans have. A second mortgage lets you turn that (usually) illiquid asset into usable cash. You’re funding yourself, so to speak.
- Low interest rates. Debt secured by a home has some of the best interest rates and lowest costs on the market.
- Multiple options for withdrawing funds. Depending on the exact vehicle, you can opt to receive money in a lump sum or draw gradually against it, using a line of credit.
- Tax advantages. If used for home-related improvements or repairs, second mortgage interest can be tax-deductible.
- Lengthy, expensive application. Applying for a second mortgage is a lot like applying for the first. It may take a while to get approval, and you’ll incur closing costs, too.
- Limits on loan size. The amount you can borrow is circumscribed by how much of your home you own outright.
- A new monthly payment. Getting a second mortgage means adding another monthly obligation to your budget.
- Puts your home at risk. Borrowing against your home means you’ll be putting it on the line; if you can’t make payments, you could lose it.
Types of second mortgages
Borrowers who wish to take out second mortgages can choose between two basic types: home equity loans or home equity lines of credit.
Home equity loan
A home equity loan comes with a fixed monthly payment. You receive all of the money upfront and pay it back, with interest, over time. This makes these loans ideal for situations where you need a sum of cash at one time, such as paying off a big debt or paying for one large single expense, like a kitchen renovation or a new swimming pool.
Before applying, do some research into current home equity loan rates. Typically rates are a few percentage points higher than mortgage rates.
To see if it makes sense for you, use Bankrate’s home equity loan calculator.
Home equity line of credit (HELOC)
A HELOC is a line of credit, similar to a big credit card. Once it’s established, you can draw on it over several years, as often as you want and in the amount that you want. You’re charged interest only on the amount that you borrow. You can repay the sums you borrow, then borrow again.
This can be a great option if you’re not sure exactly how much money you’ll need, or if you’ll need it over a long period of time. Like to pay college tuition, or a remodeling project where the overall cost isn’t yet certain. Or as an emergency fund.
HELOC interest rates are usually variable. That means they can rise and fall with the interest rate market. Like home equity loans, they’re typically a few percentage points higher than mortgage rates. They used to be lower than home equity loans, but the gap has closed in the last year.
Use our HELOC payoff calculator to see if this option makes sense for you.
What’s the difference between a second mortgage and a refinance?
Refinancing your mortgage is quite different from getting a second mortgage.
The most significant difference is that a second mortgage like a home equity loan or HELOC is a brand-new loan that you get in addition to your existing mortgage. Refinancing a loan replaces it entirely, so if you refinance your mortgage, you’ll pay off your old loan and replace it with a new one.
There’s a particular type of refinancing that allows you to tap your home equity, too. During a cash-out refinance, you take out a new loan with a higher balance than your current mortgage, pocketing the difference in cash. Of course, that leaves you with a bigger loan to pay off.
Refinancing can be a good choice if you want to adjust the repayment term of your existing loan or can secure a lower interest rate.
Final word on second mortgages
Before you take out a second mortgage, consider the risks to make sure this type of financing will work well for your situation.
The best reason to get a second mortgage is for a project that’ll increase the worth and ultimate market value of your home, via a remodel, renovation or expansion. By investing in your property, you’re using home equity to build more equity, in effect.
Using the second mortgage to pay off other loans or outstanding credit card balances is arguably another good reason — especially if those obligations carry a higher interest rate. Replacing more expensive debt with cheaper debt can be a smart financial strategy.
However, if you’re thinking about getting a second mortgage to buy a car, pay for a vacation or purchase luxuries, think twice. Do you really want to risk your home for discretionary spending?
Second mortgage FAQ
Both home equity loans and HELOCs are considered second mortgages, as they are secured by a lien on your home.
Second mortgage rates are likely to be higher than primary mortgage rates simply because the lender with the second mortgage will be second in line to be paid should your home fall into foreclosure. However, second mortgage rates still may be lower than rates on unsecured debt like personal loans or credit cards.
The choice between a home equity loan and refinance depends on your financial circumstances. The home equity loan is probably a simpler, easier proposition if you need a five-figure lump sum for certain expenses. The refinance might work better if you want to change the terms on your mortgage. A HELOC might be a better option in situations where the homeowner has ongoing financial needs, such as recurring tuition payments or a series of home upgrade projects, and wants to keep drawing money as needed. It’s also likely a better choice if you already have a good rate on your mortgage.
If you’re not sure a second mortgage is right for you, there are other options.A personal loan lets you borrow money for many purposes. They tend to cost more and have lower limits, but they don’t put your home at risk and are easier and quicker to qualify for.A cash-out refinance replaces the first mortgage on your home with a new mortgage that’s more than the current outstanding debt on your home. You then receive the difference between the existing mortgage and the new mortgage in a one-time lump sum. This option may be best for someone who has a high interest rate on a first mortgage and wants to take advantage of lower interest rates. However, mortgage rates have risen sharply in 2022, making a cash-out refinance less attractive to many homeowners. A home improvement loan, like the Federal Housing Administration’s FHA 203(k) rehab loan is another option if you’re specifically looking to pay for projects around the house.If you’re looking to turn home equity into a source of cash flow for retirement, and are of a certain age, consider a reverse mortgage.
Additional reporting by T. J. Porter