A second mortgage is a home loan taken out on a property that already has a mortgage. Also known as junior liens, second mortgages typically have a higher interest rate than the primary mortgage, and use the borrower’s home equity as collateral.
Here’s a closer look at how second mortgages work.
- There are different types of second mortgages, such as a home equity loan and a HELOC.
- There are several requirements to get a second mortgage, including a credit score of 620 and a debt-to-income ratio of no more than 43%.
- If you decide that a second mortgage isn’t right for you, there are alternatives to a second mortgage.
“Once you’ve paid enough that your home’s value exceeds your outstanding loan balance, you can choose to borrow against your home equity,” says Michael Anderson, a financial advisor and founder of Maranantha Financial in Ventura, California. “This is a second mortgage, taking out a lien against the portion of your house you own free and clear.”
To get a second mortgage, you typically need to have at least 15% equity, though some second mortgages will let you borrow up to 100% of your home’s value.
It’s called a second mortgage because if the borrower defaults on the loan, the first mortgage is the first creditor in line to recoup its losses from any sale of the property. Once the first mortgage is satisfied, the second mortgage is repaid with any leftover proceeds. That makes second mortgages riskier for lenders, which usually charge a higher interest rate to compensate.
While second mortgage rates are higher than first mortgage rates, they usually are lower than the rates on credit cards or other common types of credit.
And while most second mortgages are taken out some time after the primary mortgage, homebuyers may be able to take out a second mortgage at the same time as the primary mortgage to avoid needing to pay for private mortgage insurance. Typically, buyers who make a smaller down payment must pay PMI until their equity is at least 20% of the home’s value. A buyer with a 10% down payment can take out a primary mortgage for 80% of the purchase price to avoid PMI, and use a second mortgage to borrow the other 10%, if qualified.
Here are common types of second mortgages that lenders typically offer.
A home equity loan is paid to you as a lump sum and repaid monthly — usually with a fixed interest rate, which means your payment will stay the same for the life of the loan. The payment on the second mortgage is in addition to the payment on your first mortgage, so you need to make two mortgage payments a month.
Home equity loans typically are repaid with terms that start at five years, but can be as long as 30 years. A longer repayment term on a home equity loan would result in a lower monthly payment, but you would pay more total interest. A shorter repayment term saves you money on interest, but will come with a higher monthly payment.
Borrowers usually need to pay closing costs on a home equity loan, which generally are between 2% and 6% of the loan amount.
A home equity line of credit operates more like a credit card. Rather than paying the loan amount to the borrower all at once, it’s used to set up a line of credit that they can tap into as needed. The borrower makes a monthly minimum payment based on the amount they’ve borrowed.
HELOCs often have a draw period, typically between five and 15 years, during which the credit line can be accessed. That’s followed by a repayment period of between 10 and 20 years, where they can make no more withdrawals while they repay the loan so that it’s paid off by the end of the loan term.
A HELOC usually comes with a variable interest rate, meaning the payment will adjust from time to time depending on the borrower’s creditworthiness and market interest rates.
Uses for a Second Mortgage
There are no restrictions on what you can do with the proceeds from a second mortgage, but many borrowers spend the money on projects that increase their home’s value, Anderson says.
“This includes renovations that can make your home more valuable,” he says. “Kitchen and bathroom remodeling often increase the value of a home by more than the cost.”
Other common uses include debt consolidation or financing the purchase of an investment property. A HELOC is also a potential alternative for someone who doesn’t have other emergency savings.
Using home equity to pay for recreational activities, a risky new business, or a large event like a wedding may not be wise. Second mortgages can offer lower interest rates than personal loans, but a significant risk of taking on a second mortgage is that your house is on the line if you default on loan payments.
Requirements vary between types of mortgage lenders, but the following are common:
- A credit score of at least 620.
- A debt-to-income ratio of no more than 43%.
- At least 15% equity in your home, i.e., a loan-to-value ratio no higher than 85%.
- Closing costs, though sometimes lenders waive this.
Is a Second Mortgage Right for You?
A second mortgage is a relatively low-cost way to borrow your equity as cash. Interest rates are higher than for primary mortgages, but lower than for most other types of credit.
“If you’ve spent a few years building equity in your home and want to take advantage of that investment, a second mortgage may be a good choice,” Anderson says. “Big-ticket items like home renovations can be prohibitively expensive, and a second mortgage is one way to access the funds necessary to afford them.”
It’s also a good way to pay for expenses that will increase in value over time, or to borrow cash if you don’t plan to own the home for a long time.
“If you plan to repay your loan within five or seven years, an adjustable-rate second mortgage may save you money on interest compared to a longer-term fixed-rate loan,” Anderson says.
But there are risks involved, since you have to pay closing costs on a second mortgage and are using your home as collateral — meaning you could lose it if you default on your loan.
Pros and Cons of a Second Mortgage
|Can be used to finance expensive ventures like home renovations, or for debt consolidation or education expenses.||Your home serves as collateral, meaning you could lose it if you default on your loan.|
|Offers lower interest rates than a personal loan or credit card.||You have to pay closing costs.|
|Home equity loans and HELOCs offer different options for accessing your equity to best fit your needs.||You need enough equity in your home to borrow.|
Alternatives to a Second Mortgage
If the obstacles to getting a second mortgage seem high, here are some alternatives to consider:
- Personal loan. This typically comes with higher interest rates, but defaulting won’t put your home at risk.
- Credit card. For smaller amounts, a credit card can offer quick access. However, interest rates on credit cards are often much higher than rates on collateralized loans.
- Cash-out refinance. A cash-out refinance involves taking out a new mortgage based on your home’s current value, repaying your original loan, and keeping the remainder to use as you see fit. The cash is repaid as part of your new loan.
FAQ: What Is a Second Mortgage?
Here are the answers to some frequently asked questions about second mortgages.
A reverse mortgage is similar to a second mortgage in that it lets you borrow cash against your home equity. However, a reverse mortgage is available only to people over age 62, and requires you to own your home or have a minimal mortgage balance. Repayment on a reverse mortgage also is deferred until the borrower no longer lives in the home, while a second mortgage requires ongoing payments.
Yes. There are loans available for such borrowers, though they likely will come with higher interest rates.
Yes. A decline in your neighborhood’s home values can reduce your equity.
No. The IRS requires that you pick one residence as your primary residence, even if you split time between two places equally.
If you’re qualified, a second mortgage lets you use your home’s equity for any purpose you like. These loans typically have a higher interest rate than a primary mortgage, but a lower rate than most other types of credit. The ability to choose between a home equity loan or HELOC gives you options for how you access the money you borrow, and can give you a flexible and affordable way to consolidate debts or pay for major expenses such as home improvements or college.