What Is A Second Mortgage And How Does It Work?

There are plenty of reasons why you might need access to a large amount of money. Maybe you’re thinking about going back to school, or you need to consolidate a few high credit card balances. Or perhaps you want to do some repairs on your home?

Why not consider tapping into your home’s equity, which is usually much larger than any cash reserves you have on hand? You may be able to use a second mortgage to take care of your expenses.

In this article, we’ll cover what you need to know about second mortgages and how they work. We’ll also lay out some financing alternatives, such as a personal loan or cash-out refinance, that could be better choices for you.

A second mortgage is a lien taken out against a property that already has a home loan on it. A lien is a right to possess and seize property under specific circumstances.

In other words, your lender has the right to take control of your home if you default on your loan. When you take out a second mortgage, a lien is taken out against the portion of your home that you’ve paid off.

Unlike other types of loans, such as auto loans or student loans, you can use the money from your second mortgage for almost anything. Second mortgages also offer interest rates that are much lower than credit cards. This difference makes them an appealing choice for paying off credit card debt.

Before we talk more in-depth about what second mortgages are and who they’re for, let’s learn a little bit more about home equity. Your home equity determines how much money you can get when you take out a second mortgage.

Unless your mortgage loan has a balance of $0, a lien remains on your home. Your mortgage lender has the right to take it back if you default before you finish paying back the loan. As you pay off your principal loan balance over time, the portion of the loan that you have paid off is called equity.

Calculating your home equity is relatively easy. Subtract the amount that you’ve paid toward the principal balance of your home from the total amount you borrowed.

For example, if you bought a home worth $200,000 and you’ve paid off $60,000,  including your down payment, you have $60,000 worth of equity in your home. The interest you pay on your mortgage doesn’t count toward your home equity.

Your home equity can also increase in other ways. If you’re in a growing real estate area or you make improvements on your home, the market value of your home goes up. This change increases your equity without extra payments. On the other hand, if the value of your home goes down and you enter a buyer’s market, you may lose equity.

The equity you have in your home is a valuable asset, but unlike more liquid assets like cash, it isn’t typically something that you can utilize.

A second mortgage, however, allows you to use your home’s equity and put it to work. Instead of having that money tied up in your home, it’s available for expenses you have right now. This option can be a help or a hindrance, depending on your financial goals.

Specific requirements for getting approved for a second mortgage will depend on the lender you work with. However, the most basic requirement is that you have some equity built up in your home.

Your lender will likely only allow you to take out a portion of this equity, depending on what your home is worth and your remaining loan balance on your first mortgage, so that you still have a certain amount of equity left in your home (usually 20% of your home’s value).

To be approved for a second mortgage, you’ll likely need a credit score of at least 620, though individual lender requirements may be higher. Plus, remember that higher scores correlate with better rates. You’ll also probably need to have a debt-to-income ratio (DTI) that’s lower than 43%.

A second mortgage is different from a mortgage refinance. When you take out a second mortgage, you add an entirely new mortgage payment to your list of monthly obligations.

You must pay your original mortgage as well as another payment to the second lender. On the other hand, when you refinance, you pay off your original loan and replace it with a new set of loan terms from your original lender. You only make one payment a month with a refinance.

When your lender refinances a mortgage, they know that there’s already a lien on the property, which they can take as collateral if you don’t pay your loan. Lenders who take a second mortgage don’t have the same guarantee.

In the event of a foreclosure, your second lender only gets paid after the first lender receives their money back. This means that if you fall far behind on your original loan payments, the second lender might not get anything at all. You may have to pay a higher interest rate on a second mortgage than a refinance because the second mortgage lender is taking on increased risk.

This leads many homeowners to choose a cash-out refinance over a second mortgage. Cash-out refinances give you a single lump sum of equity from a lender in exchange for a new, higher principal. Mortgage rates of cash-out refinances are almost always lower than second mortgage rates.

Learn more about the difference between a second mortgage and a refinance by doing further research to find out which works best for you.

There are two major types of second mortgages you can choose from: a home equity loan or a home equity line of credit (HELOC).

Home Equity Loan

A home equity loan allows you to take a lump-sum payment from your equity. When you take out a home equity loan, your second mortgage provider gives you a percentage of your equity in cash.

In exchange, the lender gets a second lien on your property. You pay the loan back in monthly installments with interest, just like your original mortgage. Most home equity loan terms range from 5 to 30 years, which means that you pay them back over that set time frame.

Home Equity Line Of Credit

Home equity lines of credit, or HELOCs, don’t give you money in a single lump sum. Instead, they work more like a credit card. Your lender approves you for a line of credit based on the amount of equity you have in your home. Then, you can borrow against the credit the lender extends to you.

You may receive special checks or a credit card to make purchases. Like a credit card, HELOCs use a revolving balance. This feature means that you can use the money on your credit line multiple times as long as you pay it back.

For example, if your lender approves you for a $10,000 HELOC, you spend $5,000 and pay it back. Then, you can use the full $10,000 again in the future.

HELOCs are only valid for a predetermined amount of time called a “draw period.” You must make minimum monthly payments during your draw period as you do on a credit card.

Once your draw period ends, you must repay the entire balance left on your loan. Your lender might require you to pay in a single lump sum or make repayments over a period of time. If you cannot repay what you borrowed at the end of the repayment period, your lender can seize your home.

Rates for second mortgages tend to be higher than the rate you’d get on a primary mortgage. This is because second mortgages are riskier for the lender – as the first mortgage takes priority in getting paid off in a foreclosure.

However, second mortgage rates can be more attractive than some other alternatives. If you’re considering getting a second mortgage to pay off credit card debt, for example, this can be a financially savvy move, since credit card rates are typically higher than what you’d get with a home equity loan or HELOC.

Like any other type of loan, there are both pros and cons to taking out a second mortgage.

Pros Of A Second Mortgage

• Second mortgages can mean high loan amounts. Some lenders allow you to take up to 90% of your home’s equity in a second mortgage. This means that you can borrow more money with a second mortgage than with other types of loans, especially if you’ve been making payments on your loan for a long time.
• Second mortgages have lower interest rates than credit cards. Second mortgages are considered secured debt, which means that they have collateral behind them (your home). Lenders offer lower rates on second mortgages than credit cards because there’s less of a risk that the lender will lose money.
• There are no limits on fund usage. There are no laws or rules that dictate how you can use the money you take from your second mortgage. From planning a wedding to paying off college debt, the sky’s the limit.

Cons Of A Second Mortgage

• Second mortgages have higher interest rates. Second mortgages often have higher interest rates than refinances. This is because lenders don’t have as much interest in your home as your primary lender does.
• Second mortgages might put pressure on your budget. When you take out a second mortgage, you agree to make two monthly mortgage payments: one to your original lender and another to your secondary lender. This obligation can put a strain on your household finances, especially if you’re already living paycheck to paycheck.

Learn more about second mortgage loans and their alternatives by reading the common questions borrowers often ask themselves when looking at their financing options.

When should I get a second mortgage?

Second mortgages aren’t for everyone, but they can make perfect sense in the right scenario. Here are some of the situations in which it makes sense to take out a second mortgage:

• You need to pay off credit card debt. Second mortgages have lower interest rates than credit cards. If you have many credit card balances spread across multiple accounts, a second mortgage can help you consolidate your debt.
• You need help covering revolving expenses. Do you need revolving credit without refinancing? Unlike a refinance, HELOCs can give you access to revolving credit, as long as you keep up with your payments. This option can be more manageable if you’re covering a home repair bill or tuition on a periodic basis.
• You can’t get a cash-out refinance. Cash-out refinances, compared to home equity loans, usually have lower interest rates. But if your lender rejects you for a refinance, you may still be able to get a second mortgage. Consider all of your options before you get a second mortgage.

Should I get a second mortgage if I have bad credit?

Although second mortgages are often difficult to qualify for with bad credit, it’s not impossible. Obtaining a second mortgage with a low credit score likely means that you’ll be paying higher interest rates or using a co-signer on your loan.

You can also consider looking into alternative financing options to help pay for your home improvements or debt consolidation. Both personal loans and cash-out refinances are good options to use if you have trouble qualifying for a second mortgage.

Can I use a refinance to pay off my second mortgage?

If you have enough equity built up in your home, you could take advantage of a cash-out refinance and pay off your second mortgage. After you pay the secondary lender, you will go back to having a single monthly payment. 

Keep in mind, you will have to go through the refinance application and appraisal process with your lender. You’ll also have to pay origination fees and closing costs for your new loan. However, there’s a great chance you could have a lower interest rate, which makes this an attractive option for many borrowers.

While a second mortgage may seem like the only option to pay off your high-interest debts or fund an important renovation project, it’s not always the best financial decision. If you have a large amount of equity or a good credit score, there might be more affordable alternatives available. A cash-out refinance can give you the flexibility of a second mortgage without the higher interest rate and additional monthly payment.

That’s why it’s a good idea to take the time to consider all of your options before choosing a second mortgage over a refinance. To learn which option is better for your situation, talk to a Home Loan Expert today.