What is a Second Mortgage?
With a second mortgage, the lender loans the borrower money and the borrower’s home equity decreases. As the borrower pays back the second mortgage, their home equity increases again.
Why Take Out a Second Mortgage or Cash-Out Refinance?
You may want to take out a second mortgage because it can help cover large expenses such as:
- A home improvement
- Medical bill
- Educational bills
- Debt consolidation
- Avoiding Private Mortgage Insurance (PMI)
Second mortgages like home equity loans, home equity lines of credit, and cash-out refinance offer cheaper ways of borrowing cash than an unsecured personal loan or credit cards. By putting up your property as collateral, lenders are willing to take on more risk and to therefore offer a lower rate.
Intro to Second Mortgages
There are two common types of second mortgages: a home equity loan (HEL), a fixed-rate loan paid in one lump sum; and a home equity line of credit (HELOC), an adjustable-rate loan paid to the borrower up to an approved credit limit and on a per-need basis. Like a first mortgage, a second mortgage is secured by your home, and is used to repay the loan in the event of default.
An alternative to the second mortgage is a cash-out refinance. This works like any other mortgage refinance, except the borrower collects the difference between the old and new mortgages in cash.
If an HEL or HELOC is used to buy, build or substantially improve the taxpayer’s home that secures the loan, interest paid to the lender is tax-deductible. A cash-out refinance could be preferable to a home equity loan or HELOC if you’ve built up a good enough credit score to qualify for improved mortgage terms.
Pros and Cons
| Pros | Cons |
|---|---|
| Better rates than unsecured personal loans | Closing costs |
| Quick and easy access to loan | Increased debt burden |
| Interest is tax-deductible if used for home improvement | Putting home up as collateral can be risky |
How Much Can You Borrow?
The amount offered by lenders for a second mortgage varies, but the maximum loan-to-value (LTV) ratio tends to be around 90%. If the current value of your home is $200,000 and you still owe $160,000, then $20,000 is likely the maximum amount any lender will offer you as part of a HEL. For a cash-out refinance, the amount you can borrow depends on the difference between your original and 2nd mortgage.
How to Get a Second Mortgage: The Finances
The process of applying and getting approved for a second mortgage is fairly similar to that of applying for a first mortgage, though you may be requested more proof of income and solid repayment history for your other loans.
Your lender will ask for:
- Pay stubs
- Employment history
- Tax forms
- A social security number or driver’s license
In order to choose your second mortgage lender and finalize a loan, you’ll need to compare the rates and terms of the loan offers you’ve received. In addition to your credit score, the lender will base your rates for your second mortgage your financial information. You’ll need to prepare your documents to prove your solid financial standing. Compare rates from several lenders, and don’t be afraid to negotiate.
Before applying for a HEL or HELOC, you can take the following steps to determine your eligibility:
Check your credit
By law, you’re entitled to request a copy of your credit report every 12 months from each of the 3 major credit agencies, Equifax, Experian, and TransUnion. To see your combined FICO score from all 3 agencies, go to FICOScore.com.
Check your equity
It’ll cost you to have an appraiser come and determine the value of your home, but some lenders will let you do this and save on paying them for appraisal as part of closing costs. Additionally, there are a number of free tools on the internet that offer relatively accurate home-value estimates, such as Zillow, Trulia, and Redfin.
Check your debt
This one you can do on your own, using a calculator and receipts for all monthly expenses, including credit cards. Assuming you know your exact income, you can then divide your debt by your income to get your debt-to-income ratio.
- Loan-to-Value Ratio
When you apply for a second mortgage, lenders will take into account your combined loan-to-value (LTV) ratio – which expresses how much you owe as a percentage of your home’s current appraised value. Some lenders allow homeowners to borrow up to a combined LTV of 80-90%. If your home is appraised at $200,000, you have a loan balance of $150,000 and you take out a $25,000 home equity loan, your LTV would be 87.5% (i.e. $175,000 divided by $200,000).
- Debt-to-Income Ratio
Another thing your lender will consider is your debt-to-income ratio. Debt-to-income ratio is calculated by dividing your monthly debts (including mortgage payments, credit card debt, loans, and the home equity loan you’re applying for) by your monthly pre-tax income. Most lenders allow debt-to-income of up to 43%.
Tips for Getting a Second Mortgage
Consider the Timing:
Before taking out a second mortgage, consider whether the timing is right and try to estimate exactly how much money you need. It can be difficult to get a second mortgage with poor credit and like other loans, a second mortgage increases your debt burden and adds to your monthly costs.
Consider the Risk:
Unlike unsecured personal loans, by putting your home up as collateral you take on risk of foreclosure in the event of non-payments. Before agreeing to a second mortgage, be sure you’re not borrowing more money than you can handle and that you are sure you’ll be able to pay back every cent.
Shop Around:
If you decide to go ahead with that HEL or HELOC, shop around. As our list of lenders shows, different lenders offer different advantages. If you prefer the convenience of doing the entire application online, consider an online lender. If a low rate is your key goal, you can shop around on online loans marketplaces to find the right lender for your situation,. With so many lenders to choose from, take the time to find the one that suits you.
Know the Loan Features:
Lastly, beware of risky features like prepayment penalties that can make it expensive for you to pay back your debts earlier than scheduled. Read the fine print in your contract and always ask your loan agent if you’re unsure of anything to do with your HEL, HELOC, or cash-out refinance.
Types of Second Mortgages
Home Equity Loan
A loan in which a homeowner uses the equity, or a portion of the equity of their property, as collateral. This enables better rates than a personal loan or credit cards, and can help you qualify for a larger loan.
A home equity loan is great for you if you’re looking to take out a low-fees loan for a one time cost.
Home Equity Line of Credit
A line of credit in which a homeowner uses the equity, or a portion of the equity of their property, as collateral with flexible amounts to be used at will.
A HELOC is flexible, and you’ll only pay for the amount of money you take out and use. Because of this, a line of credit is right for someone who needs funds available, but isn’t sure exactly how much and when they’ll need it.
Reverse Mortgage
Homeowners aged 62 or more are eligible for a Home Equity Conversion Mortgage, informally referred to as a reverse mortgage. This type of mortgage works along roughly the same lines as an HEL and is guaranteed by the Federal Housing Administration. It allows seniors to draw on their home equity, receiving monthly payments or a lump sum.
Piggyback Loan
Also known as a second trust loan, this type of loan enables borrowers who can’t afford a 20% down payment to avoid paying private mortgage insurance. The borrower takes out a regular mortgage loan for 80% of a home’s value and an additional loan to cover the 20% down payment.
Second Mortgages: Home Equity Loans vs Home Equity Lines of Credit
Understand what each loan offers and what your priority is when taking a second mortgage. Do you need flexibility? Is a fixed rate important for you, or would you rather pay only for what you use?
| Home Equity Loan | Home Equity Line of Credit |
|---|---|
| Fixed rate | Adjustable rate |
| Lender pays borrower lump sum | Borrower draws funds on per-need basis |
| Less risky but less flexible | More flexible but also more risk |
| Home is used as collateral | Home is used as collateral |
Refinancing a Second Mortgage
You’ve read about first mortgages, refinancing, and second mortgages… but what about refinancing a second mortgage? Just like a first mortgage, there are many reasons a borrower might want to refinance a second mortgage, such as decreasing your payments or lowering your interest rate. If your financial situation or credit status has improved since you took out your second mortgage, it’s worth contacting your existing lender or a new lender to see if you can negotiate better terms.
Each mortgage can cost significant fees in appraisal and closing costs, so calculate the costs of refinancing your second mortgage.