What Is A Second Mortgage? Loan Types, Requirements And More
A second mortgage taps into your home equity as collateral for a second loan, which provides funds you can spend however you’d like. You need home equity for a second mortgage, which accumulates as you repay your mortgage loan or as the home’s value grows, increasing your percentage of ownership compared to the primary mortgage’s principal.
Maybe you want to remodel your kitchen or update your basement. Perhaps you’d like to consolidate debt or fund your child’s college education. A second mortgage can help you cover these types of expenses.
It's important for you to understand second mortgages to determine if they’re a good financial fit for your situation, so let's get into it.
How Does A Second Mortgage Work?
A second mortgage utilizes your home’s equity, which is its current market value minus your mortgage balance. So, if you own a home that’s worth $200,000 and you owe $80,000 on your mortgage, you have $120,000 in home equity.
Depending on your credit score and mortgage lender requirements, you may be able to borrow up to 90% of your home equity.
Since a second mortgage uses your home as collateral, it poses less risk to your lender. Therefore, it will likely come with a lower interest rate than a credit card, personal loan or another type of debt.
Applying for a second mortgage uses essentially the same process as any mortgage approval, following these general steps:
- Get a home appraisal to determine your home’s value and equity.
- Review your budget to determine how large of a second mortgage you can afford.
- Determine the loan type that’s right for you.
- Compare mortgage lenders and submit an application.
- Provide necessary financials, including income, debts, investments, etc.
- Sign the papers and finalize your second mortgage.
You can choose to take out a second mortgage with your first lender or compare their offer to other lenders to find the best rate for you. Just like your first mortgage, you can choose between fixed-rate or variable-rate loans, and your mortgage term can vary depending on the type of loan you choose.
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Types Of Second Mortgages
There are two types of second mortgages: home equity loans and home equity lines of credit (or HELOCs). While these mortgage terms sound similar, they’re two different financing options.
Home Equity Loan
If you take out a home equity loan, you get one lump sum of money as a percentage of your equity. Your lender takes out a second lien against your property, and you repay the borrowed amount plus interest through fixed monthly payments.
You may be a good candidate for a home equity loan if you know exactly how much money you need to borrow or like the idea of receiving all of your funds at once.
A home equity loan may also be a good option if you’d like to consolidate your debts because it allows you to convert your current debt into one manageable monthly payment at a lower mortgage rate.
Let’s take a look at the pros and cons of a second mortgage.
- Repayment terms: 5 – 30 years
- Best for: Homeowners who want a specific lump sum and have a stable income source
- Fixed interest rates: Since home equity loans come with fixed interest rates, you’ll know your monthly payments in advance and can avoid unwanted financial surprises.
- Lump-sum proceeds: You’ll receive your money in a lump sum so you’ll know exactly how much your loan will impact your budget.
- Closing costs and fees: You’ll likely have to pay for closing costs, usually 2% – 5% of the loan amount. In addition to closing costs, you may face an appraisal fee, title search and many other fees, depending on the lender you choose.
- Home is at risk: If you default on your home equity loan, the bank may foreclose your home.
Home Equity Line of Credit (HELOC)
A HELOC works like a credit card. You get a set credit limit that allows you to borrow as much or as little as you’d like. It’s a revolving balance, so you can borrow money within your approved limit multiple times as you repay previous debts. So, if you pay back the $2,500 you borrowed of your $5,000 limit, you have access to the entire $5,000 limit again.
This type of second mortgage involves two time periods: the draw period and the repayment period. During the draw period (which ranges from five to 10 years), you’re free to withdraw whatever amount of money you need (up to your limit). You’ll only need to make monthly interest payments on what you borrow.
The repayment period (usually 10 – 20 years) will begin once the draw period is over, at which point you’re required to pay back the principal and any interest on your borrowed amount. You won’t be allowed to borrow money from your HELOC during the repayment period.
While you can use a HELOC for any purpose, it’s a particularly good option if you have large cash needs like college tuition or a full home remodel that you want to spread out over time.
- Repayment terms: 10 – 20 years
- Best for: Flexibility for borrowing and repayment, and homeowners with a strict budget to avoid over-borrowing
- Flexibility: You don’t have to commit to a certain amount of money with a HELOC. You only use what you need.
- Delayed payments: Your payments won’t begin until you withdraw the money, at which point you’ll pay interest payments until the draw period ends and full repayment begins.
- Variable interest rates: HELOCs come with a variable interest rate that fluctuates based on the market. This means that if the market’s prime rate increases, your HELOC rate will also go up, making it difficult to budget for your repayments.
- Annual fees and other costs: You may be on the hook for a yearly membership or maintenance fee. Your lender may also charge an inactivity fee, minimum withdrawal fee or early termination fee, among other costs.
- Risk of foreclosure: Just like with a home equity loan, a HELOC uses your home as collateral, so the bank can take it if you don’t repay what you borrow.
How To Qualify For A Second Mortgage
Requirements can vary between lenders and loan types, but they generally include:
- Proof of employment and income
- At least 20% equity in your home
- Credit score of 620 or better
- Debt-to-income ratio (DTI) below 43%
These factors will also determine your interest rate and total loan approval. The better your credit score or the more home equity you have, the less risk you pose to lenders, and the better your offers will be.
Consult your lender to determine if you qualify for a second mortgage and get quotes for your budget.
Second Mortgage Rates
Second mortgage rates vary based on your financials, lender and loan type. Comparing quotes from different lenders will help you choose the best rate for you.
Typically, second mortgage rates are higher than what you were approved for your first mortgage. Your primary responsibility is to your first mortgage, so your second mortgage lender is taking on some additional risk as you balance two mortgage payments.
What To Consider Before You Get A Second Mortgage
There’s no denying that a second mortgage offers some great advantages. However, just like with any financial product, there are some consequences you should bear in mind before you take one out.
When you opt for a second mortgage, you put your home on the line because your lender will take your home via foreclosure if you stop making payments on your primary mortgage.
A second mortgage can also be expensive when you factor in interest, closing costs and fees, which may put more strain on your income. If you lose your job or face an unexpected medical bill, you could end up in some serious debt.
Below are some additional pros and cons to help you plan for a second mortgage.
- Larger loans: Second mortgages offer large loans based on your equity, so the more you’ve paid on your house, the larger loan you can get.
- Lower interest rates than other debt: Since your second mortgage uses your home for collateral, lenders can offer a lower interest rate than unsecured loans or credit cards.
- No restrictions on how you use your loan: Whether you’re going back to school, paying for a wedding or want to renovate your home, you can use your second mortgage funds how you see fit.
- Interest is tax deductible: Interest paid on second mortgages used for home improvements or builds is tax deductible.
- Higher mortgage rates: Because you’re also responsible for paying off your primary mortgage, second mortgages have higher interest rates than refinancing or your first mortgage.
- A second mortgage payment: With a second mortgage, you’re responsible for a second mortgage payment, including interest and fees. Be sure you can cover the costs without financial hardship.
- Foreclosure risk: Since a second mortgage uses your home as collateral, your lender can file for foreclosure if you fail to make your payments.
While these risks aren’t necessarily reasons to avoid a second mortgage, they are certainly important factors to consider.
The Bottom Line
A second mortgage turns your home’s equity into cash that you can use for any personal purchases you need to make. There are plenty of benefits, like a larger loan approval with lower interest rates than personal loans or credit cards, but they also put your home at risk of foreclosure and increase your monthly housing costs.
Now that you know what a second mortgage is, you can decide if home equity loans or a cash-out refinance is right for you.