What is a second mortgage?

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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).

What is a second mortgage?

When you take out 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 — in the form of a loan or a line of credit.

“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 taking out 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.

“Your home’s current value may also need to be confirmed by a third-party appraiser,” says PK Parekh, senior vice president for Discover Home Loans. The appraisal is an important part of the process because in order to qualify for the second mortgage, you must have enough equity in your home to satisfy a lender. Equity requirements vary, but many lenders prefer that you have at least 20 percent equity in your home.

You can also 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).

“When you take a second mortgage, you are able to leave your existing first mortgage in place,” adds Parekh. “Your first mortgage has a first lien position on your home, and the new second mortgage will have a second lien position on your home.”

Why would you 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.
  • College education expenses.
  • 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.

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.

Who this is best for: A home equity loan may be a good option for a homeowner who has significant equity in their home or who has a current mortgage with a particularly low interest rate, says Mike Boyle, vice president of loan operations for Freedom Financial Network. It may also be a good option for someone who needs to come up with a fairly substantial sum of money and wants a low monthly payment.

Home equity line of credit (HELOC)

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

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.

Who this is best for: A HELOC can make sense for a consumer who has significant equity in their home and has the discipline to avoid overtapping the available credit, says Boyle. It’s also best for those who don’t know the exact amount of money they’ll need to borrow upfront.

Pros and cons of 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.

Pros

  • 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 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.

Cons

  • The risk of foreclosure is present 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. Boyle says that a score in the mid- to high-700s will generally qualify consumers for the best rates.
  • 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. But be sure to get quotes from several lenders, including online lenders, and compare them in detail. Never go with the first lender that’s willing to give you a loan. In addition to comparing APRs, fees and repayment terms, look for reliable lenders that have demonstrated experience and good customer satisfaction ratings.

The bottom line

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 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. It’s also wise to examine your personal finances before you take on any new debt. Use a home equity calculator to help determine how much you can borrow and how long it will take to pay it off.

FAQ about second mortgages

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 unique financial circumstances and needs.

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 those who have a high interest rate on their current mortgage and want to take advantage of lower interest rates.

A home equity line of credit, on the other hand, 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 be able to keep drawing money as needed. It’s also a better choice if you already have a good rate on your mortgage.

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