If you’re a homeowner, you build equity every time you make a mortgage payment, or when the value of your home increases. That equity can be borrowed as cash by taking out a second mortgage or refinancing your existing loan.
But how do you know which is right for you? Here’s how each approach works, and how to decide between a second mortgage and refinancing:
- What Is a Second Mortgage?
- How Does a Second Mortgage Work?
- Second Mortgage Requirements
- Pros and Cons of a Second Mortgage
- What Is Mortgage Refinancing?
- How Does Refinancing Work?
- Mortgage Refinancing Requirements
- Pros and Cons of Refinancing
- How to Decide Between a Second Mortgage and Refinancing
- The Bottom Line on a Second Mortgage vs. Refinancing
A second mortgage is a loan taken out on a home that already has a mortgage. The second mortgage usually is secured by your home’s equity, which is the difference between your home’s current market value and what you owe on it.
You must make payments on a second mortgage in addition to your primary mortgage payments.
There are two main types of second mortgages: a home equity line of credit and a home equity loan.
A HELOC uses your equity to establish a line of credit you can borrow against as needed. It works much like a credit card, but usually has a lower interest rate.
A home equity loan is like a personal loan. You receive a lump sum secured by your equity that is repaid with monthly payments, usually with a fixed interest rate.
Second mortgages come with their own interest rates and repayment schedules. The interest rates on second mortgages usually are lower than rates for credit cards or personal loans, but more expensive than the rates on primary mortgages.
Both HELOCs and home equity loans come with equity and credit requirements, as well as possible closing costs. Your mortgage lender may cover some of these fees, but not all lenders offer second mortgages.
Second mortgages take second priority for repayment in case of foreclosure. Most foreclosed homes are sold, and the proceeds are used to repay the lender. When there are primary and secondary mortgages, the primary mortgage lender is paid in full first, with any remainder going to the second mortgage lender. That means the second mortgage lender is less likely to recoup its losses, and often will charge higher interest rates to compensate for the increased risk.
Second mortgages work much like primary mortgages in terms of the loan application process and repayment terms.
Most lenders let you borrow up to 85% of your equity with a second mortgage.
For example, if your home is worth $400,000 and you owe $300,000 on your mortgage, then your equity is $100,000 — 25% of the home’s value. That means, if qualified, you could take out a home equity loan or establish a HELOC for as much as $85,000, which you could use to pay for major expenses, such as home improvements, college tuition, or medical bills. If you borrowed the entire amount, then you would have less than 4% equity left in your home, and you’d have to make payments on your second mortgage in addition to your primary mortgage payment.
A HELOC establishes a line of credit secured by your equity that you can draw on as needed. Most HELOCs have a draw period and a repayment period.
During the draw period, which usually is five to 10 years, you can withdraw money as needed from your HELOC, up to the loan limit. This generally works like a credit card, where the credit limit is the loan amount tied to your home equity. You make minimum payments on the loan during the draw period.
Once the draw period ends, the repayment period begins. You can no longer withdraw money and must pay off the balance you’ve accumulated, plus interest. Keep in mind that some lenders require the balance to be paid in full at the end of the draw period.
HELOCs typically come with variable interest rates, which means the interest rate on the loan will change according to market factors.
Home equity loan
Home equity loans pay out a lump sum of cash secured by your equity. It’s repaid in monthly installments, usually with a fixed interest rate.
Like HELOCs, home equity loans typically allow you to borrow up to 85% of your home’s equity. Unlike a HELOC, you can’t take out more money after receiving the lump sum, and the repayment period begins as soon as you take out the loan.
Second Mortgage Requirements
Similar to your primary mortgage, secondary mortgages come with certain requirements that assure your lender you’ll be able to pay back the loan. These requirements include:
- Minimum credit score. The minimum credit score for a second mortgage usually is around 620, though a higher score may earn you a better interest rate.
- Proof of income. Lenders likely will ask for recent pay stubs, tax forms, and proof of employment, so they know you can afford the payments.
- Minimum equity. Lenders usually prefer you have at least 20% equity in your home to get a second mortgage. The more equity you have, the more cash you’ll have access to.
- Maximum debt-to-income ratio. This figure measures how much of your gross monthly income is needed to pay the minimums on your debts. Our free DTI ratio calculator can help you figure it out. Lenders typically require a DTI ratio no higher than 43%.
Pros and Cons of a Second Mortgage
While a second mortgage lets you borrow your home’s equity as cash, it does come with trade-offs.
Second Mortgage Pros and Cons
|— Interest rates are generally lower than on a personal loan or credit card.|
— You can borrow enough money to pay major expenses or consolidate high-interest debts.
— With HELOCs, you have flexibility in how much to withdraw and a delayed repayment period.
— Home equity loans have the stability of fixed interest rates.
|—There’s risk to your home if you can’t make payments.|
— Two mortgages to pay each month.
—Closing costs and fees.
—HELOCs have adjustable rates, which means payments could increase.
What Is Mortgage Refinancing?
Mortgage refinancing is when you take out a new mortgage based on your home’s current market value, and replace your existing loan.
If qualified, you can replace your current loan with a new one that has a better interest rate or a different loan term, known as a rate-and-term refinance. You also can do a cash-out refinance, where you borrow more than you need to repay your old loan, keep the difference in cash, and repay it as part of your new mortgage.
When you refinance your mortgage, you’re applying for a new loan, so many of the requirements are similar to getting a mortgage to buy a home. You also need to pay refinance closing costs, which average $5,000.
Our free mortgage refinance calculator can help you run the numbers.
A cash-out refinance pays off your current mortgage with a new loan based on your home’s current market value. You get to keep the difference between the amount you borrow and what you owe on your old mortgage as cash, and repay it as part of your new loan.
Say you bought a $400,000 home with a 10% down payment and a 30-year fixed-rate mortgage for $360,000 at a 6% interest rate. After 10 years, your home’s value has increased to $500,000, and you’ve paid down your mortgage balance to about $300,000, giving you $200,000 in equity.
If you need to pay for home improvements or send someone to college, you could refinance to another 30-year fixed-rate mortgage for $400,000, which would leave you with $100,000 in cash after repaying your original mortgage. The loan term would start over — so in addition to your monthly payment increasing, your loan payoff date would be moved 10 years into the future.
A rate-and-term refinance is when you replace your mortgage with a new mortgage that pays off your previous loan balance without borrowing any equity as cash. This allows you to adjust your interest rate and loan term, which can help you save money on interest or make your home more affordable in the long run.
Refinancing involves applying for a new mortgage, so the process is similar to the one you went through to get a mortgage to buy your home. While the requirements and specific documents you need to provide will differ depending on the lender and loan type, here are some general criteria for refinancing your mortgage:
- Minimum credit score. In general, conventional loans require you to have a credit score of 620 or higher before you can refinance. Government-backed loans may have lower thresholds.
- Proof of income. Lenders will ask for proof of employment and income.
- Minimum equity. Lenders generally will want you to have at least 20% equity to refinance.
- Maximum DTI ratio. Lenders usually require a DTI ratio of 50% or lower before you refinance.
- Minimum time. Some cash-out refinances will have seasoning requirements, which means you’ll need to wait a while after refinancing before you can refinance again. For conventional loans, that time usually is six months.
- Closing costs. You’ll have to pay fees for an appraisal, underwriting, and other services when you refinance, meaning that you’ll need cash on hand.
While refinancing can lower your interest rate and give you the option for a shorter mortgage payoff period, as well as the ability to borrow cash, it also has drawbacks. Here are the pros and cons of refinancing your mortgage:
Mortgage Refinancing Pros and Cons
|— Only one monthly mortgage payment to make. |
—Can adjust your interest rate and loan term to reduce monthly payments or the overall interest paid.
— You can borrow equity at low interest rates.
|— Must pay closing costs.|
— Extending your loan term can cost you more in interest over the life of the loan.
—Reduces the amount of equity you have in your home.
To decide between a second mortgage and refinancing, consider the overall cost.
“It is a good idea to take out a second mortgage rather than refinance when your first mortgage rate is so low that it would benefit you to keep that existing mortgage rate in place,” says Leisa Peterson, a certified financial planner and business strategist at WealthClinic in Sedona, Arizona. “On the other hand, refinancing is a good idea if you can save money both monthly and over the lifetime of the loan compared to the loan you have currently.”
Also, think about factors such as the amount of money you need to borrow, market interest rates, and how easily you can afford the new monthly payment.
Taking out a second mortgage can give you access to additional cash without having to completely refinance your loan. That saves you from dealing with closing costs or giving up a potentially great interest rate, though you’ll have a second monthly payment to make.
Refinancing allows you to adjust your loan type, term, and interest rate and repay the equity you borrow with a single monthly payment.
It’s important to think through how each approach will affect your personal financial situation and your goals when deciding which is right for you.
T.J. Porter contributed to the reporting of this article.