You gain a small amount of equity in your property every time you make a mortgage payment. You probably already know you can use that equity to borrow money. But should you refinance or should you take on a second mortgage?
We’ll take a closer look at the differences between a second mortgage and a refinance. We’ll compare both options, look at their pros and cons and help you decide which path at the fork you should take.
What Is A Second Mortgage?
When you get a second mortgage, you borrow a lump sum of cash against the equity you have in your home. You can also choose to borrow your money in installments through a credit line. There are two main types of second mortgages:
- Home equity loans: With a home equity loan, you borrow against the equity in your home with a lump-sum payment. You then pay back the loan in monthly installments with interest at a fixed rate.
- Home equity line of credit: A HELOC is a type of second mortgage that gives you continuous access to funds at a variable rate. You’ll start out with a draw period when you take out a HELOC – during this time, you can usually spend up to your credit limit without having to make any payment aside from your accumulated interest. You pay back the remaining balance in monthly installments after the draw period ends.
You’ll make repayments in addition to your primary mortgage payment. What happens if your primary mortgage and your second mortgage are from separate companies? You guessed it – you’ll need to pay each lender individually.
One major condition of a second mortgage is that lenders put a lien on your home when they give you cash or a loan. A lien is a legal claim to a property that allows the lender to seize it under certain conditions. The lender that owns your primary mortgage has the first lien on your property; your second mortgage lender has a secondary lien.
Let’s say you happen to default on your home and it goes into foreclosure. The primary lender gets its money back first, and anything left over goes to the secondary lender. This means that the secondary lender shoulders more risk for your loan; therefore, your second mortgage will have a higher interest rate than your primary one.
It’s vital to make sure you can make both payments. Losing your job or running into financial hardship may mean you’re more likely to lose your home.
It’s also important to remember that you cannot access all of the equity in your home, whether you choose a second mortgage or a refinance. For example, let’s say you have $100,000 worth of equity. Your lender might give you the option to access a maximum of $90,000. The amount of equity you must leave in your home depends on a variety of factors, including your lender, your credit score and your current debt.
Some of the benefits of taking on a second mortgage include:
- You can choose how you get your money. You can often choose between a home equity loan and a HELOC. If you need a lump sum, you’ll usually choose a home equity loan. On the other hand, if you have an ongoing project – like a home renovation – and you aren’t sure how much money you’ll need, a HELOC gives you access to a credit line. HELOCs even allow you to defer payments until after the draw period is over. This freedom of choice isn’t available when you refinance.
- You’ll encounter fewer closing costs. Home equity loan providers typically cover all or most of the closing costs associated with getting your loan. This can potentially save you thousands of dollars, as closing costs for refinances usually range between 2% – 3% of the total loan value.
- You have the option to hold onto your current loan terms. Do you have a great interest rate or are rates higher now than when you got your loan? You can hold onto your rate on your primary loan when you get a second mortgage. Second mortgages don’t replace your current loan. Instead, they add an additional payment to your monthly budget.
Some of the drawbacks of taking on a second mortgage include:
- It’s an additional lien on your property. This can put you at an increased risk of foreclosure if you can’t consistently pay both lenders.
- You’ll shoulder an extra monthly payment. You’ll need to pay your primary mortgage and second mortgage each month. Missing a payment can put you at risk of losing your home.
- You don’t have the option to change your original mortgage terms. Your second mortgage has no impact on your original mortgage loan. You cannot change your primary loan’s term, or interest rate with a second mortgage.
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When Should You Get A Second Mortgage?
If you need a lump sum of cash but you don’t want to change your mortgage terms, a second mortgage is usually the best choice for you. You’ll pay a bit more in interest on a second mortgage than your primary loan, but you’re guaranteed to keep your current interest rate on your primary loan. This isn’t always guaranteed when you refinance.
A HELOC can be useful if you have an ongoing project and you aren’t sure how much cash you’ll need upfront. With a home equity loan or a cash-out refinance, you have to know exactly how much money you need when you apply. A HELOC allows you to use your credit up to the limit and make payments as you go.
Rocket Mortgage® currently does not offer home equity loans or HELOCs.
What Is Refinancing?
You replace your primary loan with a new loan when you refinance. This allows you to choose a new lender, change your loan term, take a new interest rate or even take on a new type of loan. There are two major types of refinances:
- Rate and term refinances: Rate and term refinances allow you to change how your loan is set up without affecting your principal balance. You can lower your monthly payment by taking a longer term or you can own your home faster and save on interest by shortening it. You can also refinance to a lower interest rate if market rates are lower now than when you got your loan.
- Cash-out refinances: Cash-out refinances allow you to access your home’s equity in exchange for taking on a higher principal. For example, let’s say you have a loan with a $100,000 principal balance and you want to do $20,000 worth of repairs on your property. You’ll accept a loan valued at $120,000. Your lender then gives you the $20,000 in cash a few days after you close.
Applying for a refinance is very similar to your home purchase mortgage application. You’ll submit financial documentation to your lender first and they’ll underwrite your loan. In most cases, you’ll also need to get an appraisal before you can refinance. After the underwriting and appraisal processes are complete, you’ll attend a closing meeting and sign on your new loan. Keep in mind that you won’t get your money until a few days after closing if you take a cash-out refinance.
Some of the benefits of refinancing include:
- You can change your loan’s rate and term. You can adjust your rate and term with a refinance, which can come in handy if you’re having trouble making your monthly mortgage payments. You don’t have this option if you only take a second mortgage.
- You’ll only have to pay a single monthly mortgage payment. When you refinance, you replace your current mortgage loan with a new loan. This means that you only need to worry about making a single payment each month.
- You might be able to lower your interest rate. One lien on your property equals less risk for the lender. This means that interest rates are usually lower on cash-out refinances than second mortgages.
- It’s possible to refinance 100% of your equity. You may be able to borrow up to 100% of your home’s equity if you qualify for a VA loan.
Some of the drawbacks of refinancing include:
- It could involve higher closing costs. You’re responsible for covering all of your closing costs when you refinance. Closing costs on refinances are typically 2% – 3% of your loan’s total value. This means that if you refinance a $150,000 loan, you’ll need to have $3,000 – $4,500 in cash at closing. While it’s possible to roll your closing costs into your loan, this option also increases your monthly payment.
- You may not be able to keep your current interest rate. Your lender might require you to accept an interest rate that’s close to the current market rates. You could lose money if rates are higher now or if you originally locked into a loan with exceptionally low rates.
When Should You Refinance?
Choose a refinance if you want to change your loan’s rate or term. You can’t change the terms of your loan with a second mortgage.
A cash-out refinance might be right for you if your goal is to consolidate debt and you have plenty of equity. You’ll usually need to cover closing costs, but interest rates are lower on cash-out refinances compared to second mortgages.
A second mortgage is a loan or line of credit you take against your home’s equity. You can access your equity with a single lump sum or as a revolving line of credit during the draw period. Second mortgages allow you to use equity without altering the terms of your original mortgage. However, they also add another payment to your monthly budget and often have higher interest rates. Rocket Mortgage® currently does not offer home equity loans or HELOCs.
You can change your loan’s rate or term when you refinance. You can also access your equity with a cash-out refinance. Refinancing allows you to access equity without adding another monthly payment. However, you’ll also need to pay more at closing to finalize your new loan. Cash-out refinances are best for consolidating large amounts of debt.
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