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Second Mortgage: What It Is and How It Works

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A second mortgage is a home loan that allows you to borrow home equity while you already have a current or “first” mortgage on the property. Homeowners may choose a second mortgage to pay off debt, make home improvements or avoid mortgage insurance. Before you take out a second mortgage, it’s helpful to understand how it works and if it makes sense for you.

What is a second mortgage?

A second mortgage is a loan against your home equity and attached to a home already secured by a first mortgage. Your home equity is the difference between how much you owe and the value of your home. The term “second mortgage” refers to how lenders are paid in foreclosure: A second mortgage loan is paid only after the first loan balance has been paid. A second mortgage can be combined with a first mortgage to refinance or purchase a home.

Types of second mortgages

The most common types of second mortgages are home equity loans and home equity lines of credit (HELOCs). Both allow you to borrow against your home’s equity, but they work very differently.

Home equity loans

In most cases, a home equity loan is a fixed-rate second mortgage. You receive funds in a lump sum and pay the balance in even installments over terms ranging between five and 30 years. You’ll typically pay closing costs equal to 2% to 5% of your second loan amount and can use the cash to buy or refinance a home.

Rates are usually higher and the qualifying requirements are more stringent than a first mortgage. The funds from a second mortgage can be used to buy or refinance a home.

Home equity lines of credit

Most home equity lines of credit (HELOCs) are second mortgages, but they can be secured by a home without a first mortgage. A HELOC works like a credit card for a set time called a “draw period” during which you can use and pay the balance off as needed. The rate is generally variable and the monthly payment is based on the amount charged during the draw period.

Once the draw period ends, the balance is paid off in equal installments. Closing costs may run 2% to 5% of the loan amount. You may also pay ongoing fees for account maintenance and a close-out fee when you pay the HELOC off.

Uses for a second mortgage

It makes sense to get a second mortgage if:

  • You need to make some minor home improvements. If you don’t have the cash on hand to upgrade kitchen appliances or replace old flooring, a second mortgage can help. An added bonus: Second mortgage interest charges may be tax-deductible if the funds are used for home improvements.
  • You’re happy with your first mortgage rate but want to tap some home equity. With a second mortgage, you can convert equity to cash without touching your low-rate first mortgage. The funds can be used to pay off credit card debt, cover college tuition or as a financial cushion for unexpected future expenses.
  • You want to refinance and avoid mortgage insurance. Mortgage insurance is required if you borrow more than 80% of your home’s value on a conventional first mortgage. Some second mortgage lenders allow you to borrow up to 100% of your home’s value on a refinance without charging mortgage insurance.
  • You want to avoid mortgage insurance on a home purchase. You can buy a home with a down payment as low as 10% with a “piggyback” second mortgage. A first mortgage is taken out for up to 80% of the home’s price, and the second mortgage “piggybacks” on the first, allowing you to avoid paying mortgage insurance.
  • You need extra cash to buy a home before your current home sells. It can be hard to time the sale of your current home with the purchase of a new home. If you need to buy a new home before completing the sale of your current home, you can take out a first mortgage and a second mortgage that covers the profit you’re expecting from your current home. When your old home sells, you can pay off the second mortgage with the sale proceeds.
  • You want to borrow more equity than a cash-out refinance will allow. A cash-out refinance is when you take out a new first mortgage for more than you currently owe and pocket the difference. Most first mortgage cash-out refinance programs allow you to borrow up to 80% of your home’s value. Second mortgage loans are available up to 100% of the value of your home, although most are capped at 85%.

How does a second mortgage work?

The second mortgage process is similar to getting a first mortgage. You fill out an application, the lender reviews your income and credit history and verifies the value of your home with some type of home appraisal. However, there are a few notable differences when it comes to second mortgage requirements:

You can’t exceed the lender’s combined loan-to-value (CLTV) ratio limits. Your loan-to-value (LTV) ratio limit is calculated by dividing how much you’re borrowing by your home’s value. With a second mortgage, the lender adds the balance of both your first and second mortgage to determine your CLTV. Most lenders cap the CLTV at 85%, although some may lend you up to 100% of your home’s value.

You’ll need a higher credit score than first mortgage programs. A 620 credit score is the minimum for many second mortgage lenders, while others set the bar as high as 680.

You must qualify with two mortgage payments. A second mortgage means you’ll make two house payments. Second mortgage lenders usually require a debt-to-income (DTI) ratio of no more than 43%, although some lenders may stretch the maximum to 50%.  Your DTI ratio is calculated by dividing your total monthly debt, including both mortgage payments by your gross income.

Your first mortgage will affect the second mortgage loan amount. You’ll be limited to borrowing the difference between what you own on your current mortgage and the maximum LTV of the second mortgage program you apply for. Below is an example of the maximum second mortgage you’d qualify for if your home is worth $300,000, your current loan balance is $200,000 and the lender allows you to borrow 85% of your home’s value.

$255,000 (i.e. 85% of the home’s $300,000 value)

$200,000 (current loan balance)
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$55,000 (maximum second home loan amount)

If you have a rough idea of your home’s value and your current loan balance, try our home equity loan calculator to estimate how much second mortgage money you may be eligible for.

Pros and cons of a second mortgage

Pros

  You can access your home equity without refinancing your first mortgage.

  You’ll pay lower interest rates than a personal loan or credit cards.

  You may deduct second mortgage interest from your taxes if the funds are used for home improvement or to buy the home.

  You can buy a home with less than 20% and avoid paying mortgage insurance.

Cons

  You could lose your home if you can’t make your payments and the lender forecloses.

  You’ll pay a higher interest rate than a first mortgage.

  You’ll need a higher credit score and lower DTI ratio to qualify.

  You will net less profit when you sell your home.

Second mortgage rates: What to expect

You’ll typically pay a higher interest rate with a second mortgage. That’s primarily because the second mortgages lenders take on more risk that they won’t be paid if you default on the loan, since the first mortgage has priority in foreclosure. Home equity loan rates are normally fixed, while HELOC rates are usually variable.

In most cases, the higher your LTV ratio is, the higher your rate will be. Borrowers with credit scores of 740 or higher are often rewarded with the lowest second mortgage rates.

Check with three to five different lenders to get the best rate. Look out for ongoing maintenance costs and prepayment penalties on HELOCs.  You may get a better second mortgage rate at a local bank or credit union if you also open a checking account with them and have the monthly payments automatically withdrawn.

Second Mortgage FAQs

Can I get a second mortgage with bad credit?

Yes, but lenders will likely reduce how much you can borrow depending on how low your scores are. Home equity lenders generally require a credit score of at least 620, although some may set a minimum as high as 680. If you have a lot of equity but a lower credit score, consider an FHA cash-out refinance. Cash-out refinances backed by the Federal Housing Administration (FHA) allow you to borrow up to 80% of your home’s value with a score as low as 500.

Is it better to refinance or take out a second mortgage?

It’s better to refinance if you can get a better rate on your first mortgage or don’t have high enough credit scores to qualify for a second mortgage. A second mortgage makes more sense if you need a small loan amount, you have high credit scores and want to leave your current first mortgage as-is.

Can you get a second mortgage to buy another house?

Yes. You can take out a second mortgage on your primary residence, and use the home equity loan or HELOC funds to make a down payment on a vacation or rental home.

Can you refinance a second mortgage?

Yes. You can refinance a second mortgage with a new second mortgage. For example, if you currently have a HELOC, you can replace it with another HELOC or switch to a home equity loan.

 

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