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What is a second mortgage, and how does it work?

What is a second mortgage, and how does it work?
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The cost to buy a home in the United States has skyrocketed over the past year and a half, increasing as much as 20 percent in some cases. As a result, many homeowners suddenly have significant equity in their homes.

One of the ways homeowners can tap into equity is by taking a second mortgage, which is a loan that uses the equity in your home as collateral. Common examples include a home equity loan and a home equity line of credit (HELOC).

These types of loans are called second mortgages because they follow your first mortgage—the one you obtained to purchase the home. And like your first mortgage, a second mortgage is secured by a lien on your property, meaning if you don’t make payments or fail to repay the loan, you could face foreclosure.

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.)

“A second mortgage is simply using an existing mortgaged property to borrow money from a financial institution,” says Jim Houston, managing director of consumer lending and automotive finance at  J.D. Power. “This new mortgage is considered ‘second’ because the property has a primary or ‘first’ mortgage already established, usually for the original purchase.”

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.

How does a second mortgage work?

To obtain a second mortgage, you typically need to do the same things you do to qualify for a primary mortgage. The process includes submitting an application to a lender and providing documentation regarding your income, debts and more. You may also need to get an appraisal to confirm the 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.

Types of second mortgages

People who wish to take out second mortgages 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. The rate you get with a home equity loan will vary based on your credit, but it is possible to get a home equity loan with bad credit.

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 recoup its losses.

  • Advantages: One of the benefits of a home equity loan is that it comes with a fixed interest rate, unlike HELOCs which typically have a variable interest rate. A fixed-rate gives you stability from month to month in knowing what your monthly payments will be. Home equity loans also come with long repayment terms, which also contribute to the affordability of monthly payments.
  • Disadvantages: Taking out a home equity loan requires using your home as collateral, meaning if you fall behind on payments or are unable to repay the loan entirely, you risk losing your home.
  • Best for: A home equity loan is generally a good idea for those who have a stable source of income that can be relied upon to repay the loan.

The bottom line: A home equity loan comes with relatively low interest rates and a fixed monthly payment. You receive all of the money upfront and pay it back, with interest, over time.

Home equity line of credit (HELOC)

Home equity lines of credit are similar to credit cards but are secured with your home equity. With a HELOC, you can borrow money, repay it and use the credit line to borrow money again. As with credit cards, interest rates on HELOCs are variable.

“With a HELOC, you can borrow as much or as little as you need, whenever you need it, up to a credit limit established at closing,” says Michelle McLellan, senior product management executive at Bank of America. “As you repay your outstanding balance, the amount of available credit is replenished, which means you can borrow against it again, if needed, throughout your draw period.”

A HELOC’s draw period is typically up to 10 years. During the draw period, you may only be required to pay interest on the funds used (depending on the financing terms).

Once the draw period ends, there’s 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.

  • Advantages: The advantage of taking a HELOC is that you can borrow only the amount of money you actually need. This in turn keeps monthly payments lower for disciplined borrowers. HELOCs also offer very competitive interest rates.
  • Disadvantages: Unlike home equity loans, HELOCs often come with a variable interest rate, which can cause some unpredictability during repayment. In addition, HELOCs use your home as collateral, which can be risky if you fail to repay the debt.
  • Best for: Because HELOCs typically only require interest-only payments during the draw period, it’s easy to get in over your head and spend more than you can afford. HELOCs are best for disciplined borrowers who will not risk borrowing more money than they can repay.

The bottom line: A HELOC also lets you access the equity in your home, but you’re charged interest only on the amount that you’ve borrowed. This can be a great option if you’re not sure exactly how much of your equity you’re looking to borrow. Use our HELOC payoff calculator to see if this option makes sense for you.

Common uses for a second mortgage

Some common uses of second mortgages are to pay for:

  • College education expenses
  • Consolidation of higher-interest debt, such as credit cards
  • Home improvements
  • Medical bills

Some borrowers use second mortgages to buy an investment property. This can be risky, as a downturn in the housing market could lower the value of both properties.

Should I get a second mortgage?

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 to use the money to increase the value of your home.

Using the money from a second mortgage to improve your home’s value can maintain the equity you have in your home. Plus, 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.

If you’re thinking about getting a second mortgage to buy a car, pay for a vacation or purchase other luxuries, you should be careful. The equity in your home is one of your most important assets — think twice before using it for these types of expenses.

Requirements for applying

If you’ve weighed the pros and cons of a home equity loan or HELOC and are ready to move forward, you’ll want to start by making sure you have equity in your home. Generally, you must have at least 15 percent to 20 percent equity in your home, meaning your remaining mortgage makes up no more than 85 percent of the home’s total value.

Next, check your credit scores and reports before applying for a loan, and dispute any credit-reporting mistakes you discover. You’ll also want to gather all of your paperwork, such as pay stubs, tax returns and bank statements.

Where to find second mortgage rates

It’s a good idea to shop around. A local bank or credit union is a good place to start, but be sure to get quotes from several lenders, including online lenders, and compare them in detail. You can browse Bankrate’s lists of the best home equity loan rates and the best HELOC rates.

Frequently asked questions

What is the difference between a home equity loan and a second mortgage?

Both home equity loans and HELOCs are considered second mortgages and are secured by a lien on your home.

Are second mortgage rates higher than first mortgage rates?

Second mortgage rates are likely to be higher than first mortgage rates simply because the lender with the second mortgage will be second in line to be paid should you fall into foreclosure. However, second mortgage rates still may be lower than rates on unsecured debt like personal loans or credit cards.

Is it better to get a home equity loan or refinance?

The choice between a home equity loan and refinance depends on your financial circumstances.

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.

A home equity line of credit may be a better option in situations where the homeowner has ongoing financial needs, such as recurring tuition payments or a series of home update projects, and wants to keep drawing money as needed. It’s also a better choice if you already have a good rate on your mortgage.