Whether you need to remodel your living room or are seeking to consolidate some debt, a second mortgage allows you to borrow against your home in exchange for funds you can spend immediately. Second mortgages can be particularly beneficial for homeowners with good credit and significant home equity. Regardless of your credit or equity status, it is paramount that you understand precisely how a second mortgage works before taking the plunge.
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What Is a Second Mortgage?
A second mortgage, also known as a junior lien, is a loan taken against a home that still has its first mortgage in effect. A second mortgage is one way of turning your home equity into readily available cash without selling your home. Your home equity is the difference between the value of your house and the remaining value on your first mortgage.
Unlike your first mortgage, with the second mortgage, you cannot exceed the lender’s combined loan-to-value (CLTV) ratio. You also need higher credit than with your first mortgage, and your DTI (debt-to-income) ratio must qualify across both mortgage payments. What you still owe on your first mortgage also directly affects the loan amount of your second mortgage.
If these requirements disqualify you from a second mortgage, easily accessible alternatives include credit cards, personal loans, or cash-out refinancing.
Uses for a Second Mortgage
The most effective application of a second mortgage is to fund home renovations, such as kitchen remodels or landscaping projects. Borrowing against your home to funnel money back into it should increase its value, which in turn helps your home maintain its equity. Additionally, funds from a second mortgage allocated toward home renovations are often tax-deductible.
You can also use a second mortgage to consolidate debt, particularly if you have many active, high-interest credit cards. You can use the money from a second mortgage to pay off all your far-flung debt, allowing you to focus solely on reimbursing a single lender. Exercise caution using a second mortgage to fund superfluous luxuries like expensive cars and lush vacations. The equity in your home is one of your greatest assets, and you should not wield it lightly.
Accessing Money With Your Home Equity
Two main ways to access money through your home are home equity loans and home equity lines of credit (HELOCs for short). Each type of loan allows you to borrow against your home to fund renovations, pay college tuition, or consolidate debt, though they function quite differently overall.
Home Equity Loans
A home equity loan is a fixed-rate second mortgage. You receive your funds all at once in one lump sum and pay back your loan in fixed installments with a set interest rate over a predetermined term. These types of loans are ideal for large projects that require a lot of money.
Home equity loans require you to borrow larger sums than HELOCs and often ask you to pay interest upfront in mortgage points, which are 2-5% of your total loan amount. While this initially costs more, you’ll save more on interest over time. With longer-term periods ranging anywhere from 5-30 years and the fixed rates that come with home-equity loans, borrowers with good credit can secure negligible interest and save big over time.
Home Equity Lines of Credit (HELOC)
Alternatively, HELOCs function more like credit cards. After receiving approval from a lender, you can withdraw money from your HELOC indiscriminately over a set period (known as the draw period) instead of receiving one lump sum upfront. You are only required to make small, interest-only monthly payments during this draw period, though eventually, you must pay back all the borrowed money plus interest in equal installments.
HELOCs offer a variable interest rate that could work in your favor depending on market status at the time of the loan. However, payment periods are so long, and market rates can fluctuate so widely over the years that it may not matter. HELOC closing costs usually come to around 2-5% of your loan amount and often come with additional fees.
Can You Get a Second Mortgage to Buy Another House?
You can use your second mortgage to finance anything you so desire, even another house. Say you plan on selling your first home–you’ll probably want to have a second home lined up prior to the sale so that you still have somewhere to sleep at night. One way to procure the funds for this next home is by taking out a second mortgage equal to the profits you expect from your first home.
Using equity to buy a second home increases your buying power and allows you to borrow at lower interest rates than other types of loans and with better chances of approval. However, you risk jeopardizing your primary home, and the burden of multiple loan payments and closing costs can prove overwhelming for some people.
Can You Get a Second Mortgage if You Have Bad Credit?
Unfortunately, you probably won’t be eligible for a second mortgage if you have bad credit. Most lenders expect a score of 620 at the very lowest, though you’ll need an even higher credit score if you’re trying to borrow a markedly large amount. Higher credit scores also qualify you for lower interest rates.
Even with poor credit, you might still qualify for a second mortgage if you can find a reputable co-signer. Either way, you’ll likely be looking at less favorable interest rates than someone with higher credit. There may exist alternatives to second mortgages more readily available for those with bad credit, including cash-out refinancing or large personal loans.
Is a Second Home Mortgage Right for You?
If you have excellent credit and plan on raising the value of your home through pricey renovations, a second mortgage is the right move for you. While taking out a second mortgage can also help you consolidate debt, bankroll college tuition, or cover the down payment on a second home, it might be preferential to resort to alternatives–especially if you have poor credit. With an FHA refinance, you can borrow up to 80% of the value of your home, even with a subpar credit score. You could also consider a large personal loan or apply for a high-limit credit card.
Is It Better To Refinance or Take Out a Second Mortgage?
Instead of taking on additional debt, a cash-out refinance replaces your original mortgage with an even larger one, allowing you to pocket the difference in cash. If you have poor credit, cash-out refinances are easier to qualify for than second mortgages, and interest rates are often lower than home equity loans or HELOCs.
Refinancing is often better if you can get a favorable deal on your first mortgage or if poor credit impedes you from a second mortgage. Second mortgages are better suited for those who are just looking to borrow smaller amounts, have high credit, and don’t want to alter the status of their initial mortgage.
How Does a Second Mortgage Work
Acquiring a second mortgage can be broken down into a few key steps:
- Estimate your home equity and determine how much you need to borrow
- Provide documents proving your current income and any other debts owed
- Shop around and compare lenders
- Apply for the second mortgage and provide all necessary documents
- Receive an appraisal on the home
- Provide all documentation along with the appraisal to underwriting for approval
- Close on the second mortgage
Most importantly, weigh the risks of committing to a second mortgage before pulling the trigger. If you default on payments, your home might get foreclosed. Not only would you be marooned on an island of debt left by your first mortgage, but you would also be stuck with any additional debt borrowed via the second loan.
Second Mortgage Costs
Lenders view second mortgages as riskier ventures because second mortgages increase your overall debt and put you at greater risk of foreclosure. In the event of foreclosure or bankruptcy, this second mortgage would only receive reimbursement after the first mortgage. In light of this, you can expect notably higher interest rates with a second mortgage.
Other costs associated with a second mortgage include appraisal fees, credit check fees, and origination fees. Even though second mortgage lenders claim not to charge closing costs on paper, you’ll still be paying these over the long term. Expect closing costs hidden within the total price of the loan.
Where To Find Second Mortgage Rates
Discovering and comparing second mortgage rates should be relatively cut and dry. Start by applying for quick quotes online, and follow up with as many local banks and credit unions as possible for additional information and face-to-face assistance. Lean toward institutions you already have relationships with, as your odds of approval and securing lower interest rates will undoubtedly be higher. You might also inquire with a mortgage broker or loan originator if the terms from your bank are not to your liking.
Advantages and Disadvantages of a Second Mortgage
Clear-cut advantages that come with a second mortgage include the following:
- Accessing the untapped equity in your home without having to refinance your first mortgage
- Second mortgages have lower interest rates than credit cards or personal loans
- Funds from a second mortgage used for home improvement can be tax deductible
- You can buy a home with less than 20% down without paying mortgage insurance
On the flip side, a second mortgage could overcomplicate your finances and jeopardize your daily existence if you’re not careful. Disadvantages include:
- Losing your home if your lender forecloses on you
- A second mortgage would likely charge higher interest rates than your first
- Whenever you do sell your home, you will net less profit
- Closing on a second mortgage costs money