Second Mortgage Vs. Refinance: Which Works Best For You?

10 Min Read

Updated Dec. 12, 2023

FACT-CHECKED

You may already know that home equity is the difference between your home’s value and your remaining mortgage balance. Perhaps you also know that you can use your home equity to finance renovations or consolidate debt. If you want to convert your home equity to cash, you’ll need to decide between refinancing your existing mortgage and taking out a second mortgage.

Let’s examine the differences between second mortgages and refinances and highlight their advantages and disadvantages. Then we can help you choose the financing option that will best help you meet your financial goals.

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Is Refinancing The Same As Getting A Second Mortgage?

Cash-out refinances and second mortgages are similar in that both types of financing allow you to use the equity you’ve built in your home. However, the two options differ in how they affect your existing mortgage and monthly payments.

For instance, a refinance pays off your current mortgage and replaces it with a new home loan. The interest rate, loan term and mortgage payment amount can change. But because you’ll still only have one mortgage and one lien, you’ll continue making only one monthly mortgage payment.

On the other hand, a second mortgage will neither replace nor change your existing mortgage. You’ll keep paying on your first mortgage as planned. But because you now are responsible for a second mortgage, you’ll have an additional loan payment to make each month.

Let’s dive a little deeper into each financing option.

Cash-Out Refinance

A basic rate-and-term refinance is all you need to change the mortgage rate or loan term of your mortgage. However, if you also want to tap into your home equity so you can consolidate some debt or start investing, you’ll need to use a cash-out refinance.

A cash-out refinance is a type of mortgage refinance where you replace your existing mortgage with a larger mortgage and your lender gives you the difference in cash. Most lenders require you to have a loan-to-value ratio (LTV) of 80%, meaning you’ll be required to keep 20% equity in your home when you refinance.

Here’s how it works: Let’s say your home is appraised at $250,000 and you have $75,000 in equity. You’d be able to cash out up to $60,000 of your home’s equity.

However, let’s say you only need $25,000 for a home improvement project. You could get a loan amount of $200,000 to replace your current mortgage balance of $175,000, and your lender would give you the $25,000 in cash within 3 – 5 days after closing.

Second Mortgage

If you elect to take out a second mortgage to access your home’s equity, you have two options:

Home equity loan: This type of second mortgage loan allows you to borrow a lump sum in exchange for the equity you’ve built in your home. Like a home loan or personal loan, you’ll typically repay a home equity loan in monthly installments.
Home equity line of credit (HELOC): Much like a home equity loan, a HELOC lets you borrow money against your home equity. Instead of receiving these funds in a lump sum, however, you’ll receive the money as a line of credit similar to a credit card. During the draw period, you can borrow, repay and borrow again from the line of credit as needed as long as you don’t exceed the limit. When the repayment period begins, you’ll no longer be able to draw from the credit line, and you’ll need to make regular payments until you’ve repaid the money you borrowed.

With a home equity loan, you’ll typically borrow at a fixed interest rate, while a HELOC usually carries a variable rate. Like cash-out refinances, both home equity loans and HELOCs typically have limits on the amount of equity you can tap into.

When To Use A Second Mortgage

Home equity loans work well for debt consolidation because you’ll probably have a pretty solid understanding of the exact dollar amount you need to borrow. Home equity loans can also work well when you’re tackling a single renovation or repair project, such as replacing a roof or remodeling a kitchen or bathroom. You’ll just want to make sure you get quotes from multiple contractors so you know exactly how much to borrow.

However, a HELOC may be a better option if you need funds for several ongoing home improvement projects or you’re otherwise unsure exactly how much equity you’ll need to use.

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Cash-Out Refinance Vs. Second Mortgage: Pros And Cons

Let’s explore the benefits and drawbacks of both cash-out refinances and second mortgages to help you determine which financing option works best for you.

Advantages Of Cash-Out Refinances

You can change your mortgage rate and loan term. Refinancing could give you the opportunity to lock in a lower interest rate. That’s possible if your credit score has improved or mortgage rates have decreased since you closed on your loan. You can also change your loan terms by refinancing from an adjustable-rate mortgage to a fixed-rate mortgage. If you want to pay off your mortgage sooner, you can refinance to a 15-year term, but you can also use a refinance to lengthen your loan term to, say, a 30-year fixed-rate mortgage if you’re looking to lower your monthly payments.
You’ll only have one monthly payment. Instead of taking on a second mortgage, you’ll be refinancing. This involves replacing your current mortgage with a new loan, which means you’ll still only have one mortgage payment to make each month.
Your interest rate may decrease. Because you’ll still only have one mortgage, you’ll also only have one mortgage lien. The fewer liens on your home, the less risk your property presents to lenders, which will likely result in a lower interest rate than you’d have with a second mortgage.
You could possibly refinance 100% of your home’s equity. Some types of cash-out refinances don’t have limits on the amount of equity you can refinance. For example, if you’re an eligible active-duty service member, veteran or surviving spouse, you may qualify to cash out 100% of your home equity with a VA cash-out refinance.

Disadvantages Of Cash-Out Refinances

Your monthly payments will likely increase. To cash out your home’s equity, you’ll have to refinance to a larger loan amount than you’re currently paying on. Unless you’re locking in a considerably lower interest rate, the larger loan amount will likely increase your monthly mortgage payment.
You’ll have to pay closing costs. Closing costs typically range from 2% – 6% of your loan amount. If you refinance a $200,000 loan, you may have to pay $4,000 – $12,000 at closing or roll these costs into your loan, which will further increase your monthly payments.
You could end up with a higher interest rate. If mortgage rates have increased since you closed on your home loan, you may lose money by having to accept a higher interest rate.

Advantages Of Second Mortgages

You can choose how you receive your funds. With a refinance, you must accept your cashed-out equity as a lump sum. With a second mortgage, you can receive your funds as a lump sum (home equity loan) or as a revolving line of credit (HELOC) to borrow from and repay as needed.
You may pay fewer closing costs. Your mortgage lender will often cover the closing costs on your home equity loan or HELOC. Even if they don’t, you’ll be paying closing costs on a much smaller loan amount than if you refinanced.
You can preserve your current loan terms. If you’re happy with the interest rate on your primary mortgage loan, a second mortgage allows you to avoid changing your current loan terms.

Disadvantages Of Second Mortgages

You’ll have two mortgage liens and two monthly payments. As stated earlier, more liens on your property could equal a higher risk of foreclosure in the event you default on your mortgage payments. A second mortgage means an additional mortgage payment each month, which could put strain on your budget. Missing a payment on either mortgage increases your risk of foreclosure.
You’ll likely have a higher interest rate. Because of the added risk that comes with having multiple liens on your property, second mortgages often have higher interest rates than cash-out refinances.
You won’t be able to improve the terms of your first mortgage. Unlike a cash-out refinance, you won’t have the chance to lower the interest rate or change the loan term of your primary mortgage with a home equity loan or HELOC.

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How To Choose Between A Cash-Out Refinance Vs. A Second Mortgage

Now that we’ve examined the pros and cons of cash-out refinances and second mortgages, let’s look at some different scenarios to help you decide whether a HELOC, home equity loan or cash-out refinance best fits your needs.

When To Take Out A Second Mortgage

You want to avoid paying closing costs. Your lender may waive your origination fee and other closing costs on a second mortgage. But even if you have to pay, the fees will likely be substantially lower than for a refinance. Note: You still have to pay closing costs on a home equity loan.
You don’t want to change your current mortgage terms. With a second mortgage, you can tap into your home equity while keeping your current loan term, interest rate and monthly payment.
You’re not sure how much you need. Instead of paying back a lump sum over time, HELOCs give you the flexibility to only draw as much of your credit limit as you need at any point before the repayment period kicks in.

When To Get A Cash-Out Refinance

You’d like to lock in a lower mortgage rate. If you have good credit, the market is right and you meet your lender’s underwriting standards, you may qualify for a lower interest rate with a cash-out refinance.
You only want to be responsible for one mortgage payment. Instead of adding a second mortgage, a cash-out refinance replaces your original mortgage so you only have to keep up with one payment each month.

The Bottom Line

Both second mortgages and cash-out refinances give you access to your home’s equity so you can consolidate debt, pay for a home renovation and more. Your goals and your financial situation will determine whether taking out a second mortgage or refinancing an existing one makes the most sense for you.

Need some more help deciding between a home equity loan and a cash-out refinance?