Second Mortgages: What They Are And How They Work
Maybe you want to remodel your kitchen remodel 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. As long as you have equity in your home, you may be able to take out a second mortgage and meet your financial needs.
While Quicken Loans® does not offer second mortgages currently, it’s still important for consumers to understand what they are to determine if they’re a good financial fit. Our guide can help.
What Is A Second Mortgage?
A second mortgage is a loan you take out against a home that already has a mortgage. At its core, a second mortgage allows you to use your home as collateral to gain access to the cash you need to pay for just about anything.
How Does A Second Mortgage Work?
With a second mortgage, you tap into 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 lender requirements, you may be able to borrow up to 85% of your home equity.
Since a second mortgage uses your home as collateral, it poses less of a 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.
Types Of Second Mortgages
There are two types of second mortgages: home equity loans and home equity lines of credit.
Home Equity Loan
If you take out a home equity loan, you get one lump sum of money that you pay back via fixed monthly payments over an agreed-upon term. 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 can allow you to convert your current debt into one manageable monthly payment at a lower interest rate. Let’s take a look at the pros and cons of this type of second mortgage.
- 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, which are usually 2% – 5% of the entire cost of the total loan. In addition to closing costs, you may face an appraisal fee, title search fee and a number of 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
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. If you prefer the flexibility of being able to borrow money as you need it, a HELOC can make sense.
This type of second mortgage involves two time periods: the draw period and the repayment period. During the draw period (which can range from 5 – 10 years), you are 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 and require you 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. The pros and cons of a HELOC include:
- 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.
- 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 go up as well. This can make 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 and early termination fee, among other types of fees.
- 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.
Common Uses Of Second Mortgages
While there are a number of ways you can use a second mortgage, some of the most common include:
- Paying off a loan: A second mortgage can give you the chance to pay off a loan with a high interest rate and potentially save hundreds or even thousands of dollars.
- Funding home improvements: If you want to remodel your kitchen or add a deck, a second mortgage can allow you to do so.
- Paying for big purchases: Whether you’d like to go on a vacation, buy new furniture or do anything else that requires a lot of cash, a second mortgage is a viable option. You can use it to pay for a big purchase you may not be able to afford otherwise.
- Navigating a financial emergency: In the event your car breaks down or your child requires a last-minute medical treatment, a second mortgage can save the day.
Who Is Eligible For A Second Mortgage?
Every lender has their own specific set of requirements for a second mortgage. In most cases, however, they include:
- Proof of employment and income
- At least 20% equity in your home
- Minimum credit score of 620
- Debt-to-income ratio (the portion of your income that goes toward debt) below 43%
Things To Consider When Getting 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. Also, a second mortgage can be expensive when you factor in interest, closing costs and fees. In addition, it 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.
While these risks aren’t necessarily reasons to avoid a second mortgage, they are certainly important to consider.
Understanding How A Second Mortgage Works Through An Example
The best way to understand how a second mortgage truly works is with an example. Let’s say Jordan and Sammy own a home worth $250,000 (their initial mortgage amount was for $200,00, but their home has appreciated in value). They have a 30-year mortgage with an annual percentage rate (APR) of 3.4%. They have just $75,000 dollars still to pay down from their initial mortgage’s balance, and they have both received several raises since they bought their home. Their credit scores are excellent and they are feeling very comfortable financially.
When they speak to their lender about a home equity loan, the lender tells them that they can borrow up to 85% of their home’s value minus the amount remaining on their mortgage. That means they can borrow $212,500 (85% of 250,00) - $75,000, or $137,500. Their lender offers them an APR of 5.6% (currently a fairly standard rate for a home equity loan), on that loan.
Jordan and Sammy take the deal as a 15-year fixed-rate mortgage and use $125,000 of the loan to build a major addition onto their home and $12,000 to pay off higher-rate debt.
They are now paying two mortgages: their first mortgage, with a payment of $887 per month, and a second mortgage, with a payment of $1,131 per month. Their total monthly payments have gone from $887 to 2,018.
Assuming Jordan and Sammy take the full 15 years to repay their home equity loan, at an APR of 5.6%, the loan for $137,000 will cost them $202,803. That’s an expensive loan! And it might be even more expensive than it seems if you consider the fact that they could have instead been putting more money into their first mortgage to pay it off early.
It’s possible that the addition they built onto their home will help them sell it for substantially more money, and there’s always comfort and quality of life to consider, but some might say that this second mortgage was not a financially savvy move for Jordan and Sammy.
How To Get A Second Mortgage
If you’re interested in a second mortgage, follow these steps:
- Take a close look at your financial situation: Find out your credit score, then calculate your DTI and whether you can afford to take on additional debt.
- Figure out how much home equity you have: Subtract your mortgage balance from the current market value of your home.
- Determine the type of second mortgage you’d like: Are you interested in a home equity loan or a HELOC? The answer will depend on whether you prefer a lump sum of money or a revolving line of credit.
- Shop around: Do some research to find lenders that offer your second mortgage of choice. Banks, credit unions and online lenders are all good places to look.
- Speak to a Home Loan Expert: [note: link changed] Once you’ve found an option or two that meets your budget and needs, it’s a good idea to consult a Home Loan Expert. They can answer any questions you may have and ensure you’re making a smart decision.