For most American homeowners, their home is, by far, their greatest asset. Thankfully, there’s a very convenient way to borrow against that asset called a second mortgage. And as you’ll see, there are numerous advantages to taking a second mortgage, especially compared to other types of loans.
What is a second mortgage
In simple terms, a second mortgage is a loan on property that already has a loan. When you have a house with a mortgage, as most homeowners do, you can take out a second mortgage if you have enough equity in your house to secure that loan. The second mortgage is a loan that is secured by a second lien on the property. So you can’t sell your house until you’ve paid off the second mortgage as well as the first.
In fact, the mortgage lender can even take over ownership of your house if you default on your loan, just as with a first mortgage. In that case, the lender would sell your home and use the proceeds to pay off the remaining balance on the second mortgage, but only after the first mortgage is paid off. So the second mortgage gets its name in part due to the fact that the lender is in the second position to be paid when the home is sold.
A second mortgage can take the form of a home equity line of credit, or HELOC. Rather than dispersing all of the funds at once, like many other types of loans, a HELOC allows you to draw on the funds as you need them, and if you need them. In fact, many homeowners have a HELOC with zero balance so that they can use it to access funds at some time in the future.
Since there are no restrictions on how you can use the funds from a second mortgage, homeowners have found a wide variety of uses for them. Some use their loan to consolidate and pay off existing debts, while others will use them to fund the purchase of a vehicle, a home improvement project, resolve a financial emergency or even to take a vacation.
How does a second mortgage work
When you apply for a second mortgage, you’re relying on the equity in your home as collateral. Your home equity is calculated by taking the value of your home, and subtracting what you owe on your first mortgage.
For example, the median home price in the United States in 2020 was $284,600. If you purchased your home for that price at that time, and you made a 20% down payment of $56,920, then you owed $227,680 on your first mortgage at the time of purchase. That means that the amount of your down payment, $56,920 equaled the equity that you had in your home when you purchased it. If its value has risen by 5% since you purchased it, then it would now appraise for $298,830. If you subtract the $227,680 of the original loan amount, you would now have $71,150 of equity.
Actually, you would have even more home equity, since presumably you would have paid off some of your first mortgage over the course of the year, reducing the outstanding balance of your first mortgage.
So you can see how your home equity can quickly increase each year that your home appreciates and as you pay down your first mortgage. Your home equity can also increase if you make significant improvements to your property that increase its appraised value. On the other hand, your home equity can decrease if the value of your house goes down due to a poor real estate market, or if your home is damaged or if it deteriorates into a state of disrepair.
Types of second mortgages
Just like there are many types of home mortgages, there are also many kinds of second mortgages. The simplest type is a home equity loan. A home equity loan allows you to access cash in a single payment, using your home’s equity as collateral and establishing a lien on your property. This is an installment loan that you make monthly payments on, including interest, just as you would with your first mortgage.
Another type of second mortgage is a home equity line of credit (HELOC). As mentioned, this is a line of credit that you can draw on, and pay off at any time. You can repeatedly pay off and borrow from the line of credit if you choose. Once you’ve accessed the HELOC, you will have to make monthly payments of at least the interest incurred. And as you pay down the principal, you’ll free up the line of credit for later use. A HELOC also uses a lien on your home as collateral.
You can access this line of credit in multiple ways. Most HELOC lenders allow you to transfer the money to your checking account or write a check against it. Some may even offer the ability to pay bills electronically with your line of credit or even issue you a debit card that can be used to draw funds from the loan. And unlike other types of loans, there’s no limitation on what you may use your HELOC for.
Another, less common type of second mortgage is the so-called piggyback loan. This is when you take out a loan to cover part of the down payment on the first mortgage. Using a piggyback loan can allow you to put down the 20% down payment in order to avoid private mortgage insurance (PMI) or a more expensive jumbo loan. Jumbo loans are those exceeding the limits of loans that conform to Fannie Mae, Freddie Mac or FHA lending requirements.
Pros and cons of a second mortgage
As with any type of financial product, a second mortgage comes with important advantages and drawbacks to consider.
One advantage of a second mortgage is the high loan amount you can receive. Many lenders allow you to access up to 90% of your home’s current equity as a HELOC or another kind of second mortgage. However, you may receive better rates if you only need to borrow 80%.
And because your second mortgage is secured by a lien on your property, it can have a much lower interest rate than a personal loan, a credit card or other types of unsecured loans. That’s because there’s far less risk to the lender in case you default, as the lender can always take possession of your home and sell it to recover the remaining balance of the amount.
And remember, there are no limits on how you can use the money you withdraw from a home equity loan or a home equity line of credit. In contrast, most other types of loans, like car loans, home improvement loans and vehicle loans are granted to borrowers for use only for a specific purpose. For example, in order to receive a car loan, you’re often limited to the purchase of a vehicle that conforms to the lenders requirements, including age and mileage. And with a home improvement or construction loan, the lender will typically have to approve your plans and will insist on paying the contractors directly. But with a second mortgage, the money from the loan is yours to spend as you wish.
Also, there are potential tax benefits to having a second mortgage. Like your first mortgage, you may be able to take a tax deduction for interest payments made. According to the Tax Cuts and Jobs Act (TCJA) that went into effect in 2018, the interest charges from a second mortgage can be tax deductible if the loan is used to "buy, build, or substantially improve" your home.
Nevertheless, there are several downsides to a second mortgage. For example, second mortgages will have higher interest rates than first mortgages. Also, second mortgages tend to have variable interest rates. This is good when rates are low, but if rates go higher, it can cost you much more in interest payments. For that reason, a cash out refinance could be a better option for some homeowners. Having a second mortgage also means having another loan that you’ll have to pay off.
Requirements for a second mortgage
The requirements for taking out a second mortgage are much like those of a first. You’ll have to have proof of employment or another acceptable form of income. That means that you’ll have to provide W2 form, recent pay stubs or other forms of proof of income.
You’ll also need to have at least a good credit score, which is typically considered to be around 620 or above. Another requirement that most lenders will have is a debt to income ratio of less than 43%. This means that the total amount of all of your monthly payments, including the second mortgage, must be less than 43% of your monthly income.
As part of the process, the lender will almost certainly order an appraisal of your home. In the past, this meant having to schedule an appraiser to come by your home and inspect it to determine its value. But in recent years, so-called drive by appraisals which don’t require entry to your home, have become more common. Either way, you should expect the cost of the appraisal to be among the fees that you have to pay before you close on a second mortgage.
How to get a second mortgage
First, you’ll want to ensure that you meet the qualifications for a second mortgage. Start by looking at your credit score, which you can do with one of the many free services offered by credit card issuers. You’ll also want to add up your total amount of loan payments and be sure that it’s less than 43% of your monthly income.
Next, you’ll want to begin shopping around for the second mortgage. It’s a good idea to start with banks, credit unions and other institutions that you already have an existing relationship with, such as the lender that holds your first mortgage. But you should also investigate other lenders who might be able to offer you more competitive rates and lower fees.
Once you’ve found the best lender for your needs, you’ll need to submit an application. This is where you’ll need to submit documentation including proof of income. Expect the lender to check your credit reports and to order an appraisal of your property. But if the appraisal and the other documentation checks out, a second mortgage can close very quickly. Just like any other home mortgage or refinance, once you’ve submitted your application, you should refrain from applying for any new loans or lines of credit until the loan closes.
Frequently Asked Questions about Second Mortgages:
What is the difference between a home equity loan and a second mortgage?
These two terms have more in common than they have separating them. The term second mortgage refers to the lien on your property that’s second to the primary mortgage. A home equity loan is a loan that’s secured by a second mortgage on your property. Home equity loans and home equity lines of credit are the two most common types of loans that require a second mortgage.
How much equity do you need for a second mortgage?
You don’t need a specific amount of equity, but the more you have, the greater your loan or line of credit will be. Most lenders will loan an amount equal to either 80% or 90% of your home’s equity. But if you have very little equity in your home, then the costs of a second mortgage might be too high to justify.
What is the difference between a first and second mortgage?
A first mortgage is the primary loan used to purchase the property. The second mortgage is an additional loan that’s taken out, using the remaining equity as security. In the event that you default on the first mortgage, the second mortgage or both, then the lender can take possession of the house, sell it and use the proceeds to pay off the loan. If this happens, the proceeds are first used to pay off the first mortgage, and then what’s left over will pay off the second mortgage. Any funds remaining, after taxes, fees and administrative costs are returned to the borrower.
Will a second mortgage hurt my credit?
In most cases, it will not. So long as you pay your bills on-time, and you don’t incur too much debt, then your credit score should stay the same or better. But if you miss payments, or you continuously max out your line of credit, then you could see your score drop.
Is it better to get a second mortgage or refinance?
This depends on your particular situation. A cash out refinance has the advantage of potentially offering you a lower interest rate and you’ll have just one payment to make. On the other hand, a second mortgage is likely to be faster, easier and have fewer costs. And as you pay off the second mortgage, your monthly payments will decrease. Yet the interest rate of a second mortgage can go up if it’s a variable rate.