How Does a Second Mortgage Work, and Should I Get One?
Learn about the options and risks of taking out a second mortgage
A second mortgage is an additional loan you take out with your house as collateral while another loan is secured by that property.
Some people take out a second mortgage to make a down payment, while others do so to pay off debt or complete home improvements. However, the far-reaching impacts of the decision mean that you shouldn't take it lightly.
If you are deciding whether to obtain a second mortgage, it is important to understand how it works, how to take one out, and how it will affect your finances now and in the future.
How a Second Mortgage Works
Similar to a first mortgage, a second mortgage is a loan that is secured by your home, except it is an additional loan you take out on a property that is already mortgaged.
The mortgage is termed "second" because the loan will be paid second if you can't pay your mortgages and your home must be sold to pay off the debts. Interest rates on second mortgages also tend to be a little bit higher than those of first mortgages because the lender involved in the second mortgage will receive money only after the first mortgage is paid off. A second mortgage carries similar risks as a primary mortgage if you fail to make payments on the loan, including the risk of the foreclosure and loss of your home.
There are two common types of second mortgages:
- Home equity loans (HELs): These loans can be classified as "closed-end" second mortgages because you receive the loan proceeds once and can't draw from them again after you use them up.
- Home equity lines of credit (HELOCs): These are considered "open-end" mortgages because you can draw up to certain credit limits, pay down the balance, and then draw up to the limits again.
How a Home Equity Loan Works
A HEL uses the equity in your home as collateral. Equity is what your home is worth minus the existing mortgage.
You generally receive the loan proceeds as a lump sum with a loan term ranging from five to 30 years, and you will have to repay it plus interest in fixed monthly installments. There may also be upfront fees. Fortunately, the interest rate is generally fixed and doesn't change over time, which makes for a predictable monthly payment. But if you don't repay the HEL, the lender could foreclose on your home.
How a Home Equity Line of Credit Functions
A HELOC is a revolving line of credit that allows you to repeatedly "draw" from or borrow against your home equity.
When you open a HELOC, you will be given a set of checks or a credit card that you can use to draw the money as you need it up to the lender-approved maximum line amount over a "draw period" that lasts for a fixed term, usually 10 years. As you make payments, funds are available again in your HELOC to draw from again. A HELOC is similar to a credit card in this respect because you can continue to access the available balance as long as the line of credit is open.
When the draw period ends, you enter another fixed period of years known as the repayment period, which may last for 20 years. During this period, you must pay the balance you owe in regular payments that include the principal and interest. The interest rate on a HELOC is variable, which can result in payments that fluctuate from month to month. Some HELOC lenders and agreements even require you to pay the amount you borrowed in full immediately when the repayment period starts. If you don't make payments as required, your property could go through foreclosure and your credit score could decrease.
The biggest risk of home equity loans or home equity lines of credit is that you could lose your home because you are using the equity in your home as collateral.
Options for Using a Second Mortgage
There are a few common scenarios for obtaining a HEL or a HELOC, but each merits careful evaluation and comes with lower-risk alternatives.
Using a Second Mortgage as a Down Payment
Some people use a second mortgage to cover a down payment or even closing fees that they can't otherwise afford. Others take out what is known as a "piggyback" second mortgage to qualify for their main mortgage and avoid paying Private Mortgage Insurance (PMI) even if they don't have enough to make a down payment of 20% on their home. For example, instead of paying 10% of the home value with a down payment and 90% of the remaining value with a mortgage that requires PMI, a borrower can qualify for a 10% down payment, 80% of the mortgage, and 10% with a piggyback second mortgage.
But a second mortgage or a piggyback second mortgage both come with higher interest rates. You could also become underwater on your mortgage. Making a down payment of 20% will allow you to avoid paying PMI, qualify for lower interest rates on the first mortgage, and start your home loan on better financial footing. More importantly, you can avoid potentially losing your home.
Taking out a Second Mortgage to Pay off Debt
Debt consolidation is a common debt management strategy that involves combining multiple debts into one, typically lower-interest loan. People who have built up sufficient equity in their home sometimes take out a second mortgage so that they use their home equity to pay off high-interest debt. However, this strategy doesn't actually pay off the underlying debt; you are simply taking out a new loan to pay for an older one. This is why some people consolidate their debt and then find themselves in debt again within a short amount of time.
Even if you qualify for lower interest rates on a second mortgage than on your credit card or personal loan debt, taking out a second mortgage to pay off debt puts your home at risk because you are moving unsecured debt to your home. If you cannot make your payments, the lender could foreclose on your property and you could lose your home.
With the changing values of homes, taking out an additional loan against your home could be a major risk if your home's value declines to the point that it is worth less than the mortgage, at which point you would be underwater on your mortgage and would be more likely to default on your mortgage.
It is better not to tie additional debt to your home if you can avoid it. Instead, speak with a debt settlement company to resolve the debt and a credit counseling company to address the problems that caused you to go into debt in the first place. If you decide to consolidate your debt, consider taking out a consolidation loan from a bank instead.
Using a Home Equity Loan to Get Cash
Some homeowners choose to use a home equity loan to trade the equity that has built up in their home for cash for home improvements or other expenses. You may be able to get between 90% to 95% of the cash value of the equity by putting up your home as collateral for the second mortgage. However, you will have two mortgage payments, and you create the risk of losing your home if you fail to make payments.
An alternative is a cash-out refinance, which refinances your existing loan into a new loan and allows you to receive the difference in cash. The terms, interest rates, and payment plan for the consolidated loan will be different from the original loan, but you will not have two loans to contend with. A cash-out refinance is particularly attractive if you can secure a lower interest rate on the consolidated loan than on a second mortgage.
Of course, you may wish to forgo both options and instead preserve the equity in your home for when you retire or when you sell the home and move to a new one.
Taking out a Second Mortgage
Once you understand how a second mortgage works and deem it to be the best course of action for you, how to take out the additional mortgage is similar to getting your first mortgage. You will likely need to provide proof of your employment, income, credit score, and other debts. You will also need to have sufficient equity in your home. You will need to get your home appraised to get an estimate of its current value so that the lender can assess the equity. The loan amount and interest will reflect all of these factors.
You can begin the application process by going to your bank or credit union and applying for a loan through them. Inquire about whether the lender charges application, origination, or appraisal fees; not all lenders charge these fees. Although you should be prepared for the interest rates on a second mortgage to be a bit higher than on your first mortgage, they will still generally be lower than unsecured loans such as personal loans or credit cards.
You don't have to get your second mortgage from the same lender where you received your first mortgage.
Adding a Second Mortgage to Your Debt Payment Plan
After you take out a second mortgage, include it in your debt payment plan. Since the interest rate is higher, it should not be treated the same way as your primary mortgage. Work to pay off the debt from a second mortgage as quickly as possible to avoid becoming mired in more debt.
If you are considering a second mortgage for any reason, consider carefully the reasons why you are doing it and whether or not you can truly afford the financial and emotional costs of a second mortgage, including the potential loss of your home.
You will usually be better off if you can save up and pay cash for most of your needs or work with debt professionals to clear up your debt without the same risks as using a second mortgage to pay them off.
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