Second Mortgage Vs. Refinance: What’s The Difference?
Victoria Araj7-minute read
June 20, 2022
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?
Let’s take a closer look at the differences between a second mortgage and a mortgage 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 and if needed, you still have the option to refinance a second mortgage.
What Is A Mortgage Lien?
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 mortgage 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.
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Types Of Second Mortgages
There are two main types of second mortgages: home equity loans and home equity lines of credit. It’s important to note that Rocket Mortgage® does not offer home equity loans or HELOCs.
With both of these types of second mortgages, 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 both lenders individually.
Home Equity Loans
A home equity loan is a type of second mortgage that lets 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 Lines Of Credit
A home equity line of credit (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.
Advantages And Disadvantages Of Second Mortgages
When it comes to second mortgages, it’s important to learn the advantages and disadvantages that go along with it. Let’s take a look at both to learn whether a second mortgage might be the best option for you.
Pros Of Taking Out A Second Mortgage
Some of the benefits of taking on a second mortgage include:
- Flexibility: You can choose how you get your money. You can often pick 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.
- 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.
Cons Of Taking Out A Second Mortgage
Some of the drawbacks of taking on a second mortgage include:
- Additional lien: Taking on another lien to your property puts you at an increased risk of foreclosure if you can’t consistently pay both lenders.
- Two monthly payments: 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.
- Can’t improve first mortgage terms: 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.
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.
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Types Of Refinancing
There are different types of refinancing options you can choose from but before we get into them, let's look at what goes into the process of applying for a refinance.
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 close 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.
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 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.
Advantages And Disadvantages Of Refinancing
If you’re planning on refinancing, knowing the advantages and disadvantages that go with it are important when choosing. Let’s look at some of the pros and cons when it comes to refinancing.
Pros Of Refinancing
Some of the benefits of refinancing include:
- Change your existing 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.
- 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.
- 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.
- 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.
Cons Of Refinancing
Some of the drawbacks of refinancing include:
- 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.
- Forfeit 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.
Is It Better To Get A Second Mortgage Or Refinance?
Choosing between a second mortgage and refinancing is different when it comes to each person and their financial situation. If you’re unsure, let’s look at some of the reasons you might choose one option over the other.
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 or need to pay for a large expense and you have plenty of equity. You’ll need to cover closing costs, but interest rates are lower on cash-out refinances compared to second mortgages.
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 could be 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.
The Bottom Line: Learn The Difference Between Refinance And Second Mortgage To Help You Decide
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. Second mortgages are best if you already have a good interest rate on your mortgage and need extra funds for a home repair or a child’s college education.
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. You can change your loan’s rate or term when you refinance.
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