What is a Second Mortgage and How Does it Work?
When you purchase a home you’re likely to make a down payment and engage with a mortgage lender to borrow the rest of the purchase price of the home. This loan is known as a mortgage, but it is sometimes called a first home mortgage to distinguish it from a second home mortgage. Your mortgage is secured by using your home itself as collateral, meaning that if you stop making payments before the loan is completely paid off, the lender can take possession of your home.
What is a second mortgage?
After you have built enough equity in your home, you may be able to take out a second mortgage as an additional secured loan that uses your home as collateral. While the new loan increases your outstanding mortgage debt, it gives you cash that you can use for important needs, such as debt consolidation, home improvement, and major expenses. Because a second mortgage is tied to the equity you have in your home it is often called a home equity loan.
How does home equity work?
The equity you have in your home is the part of your home’s value that you own outright. Calculate home equity as the difference between the market value of your home and the amount you owe on your mortgage(s). You may be able to borrow against your equity when you need cash. Consider this example of equity:
In year 1, you buy a home for $300,000, making a 20-percent down payment ($60,000), and borrowing a first mortgage of $240,000 from your lender. You have $60,000 in equity.
In year 5, after making regular payments of interest and principal, you have paid down part of your loan and now owe only $210,000, putting your equity at $90,000.
At the same time, the housing market is booming and the appraised value of your home has gone up to $400,000 so you have seen a price appreciation of $100,000. Now your market value of $400,000 minus your outstanding loan amount of $210,000 gives you equity in your home of $190,000.
Your home equity lender may allow you to borrow up to 90 percent of your home’s market value (in some cases 95%, depending on your credit score), which would be $360,000. Subtracting your remaining first mortgage amount of $210,000 from this amount gives $150,000 as the additional amount that you could possibly borrow as a second mortgage.
How to use a second mortgage
When you take out a second mortgage, you have ultimate freedom in deciding what to do with it. However, financial advisors strongly recommend that you use this money wisely for items that have lasting value, such as making a home improvement, investing in education and funding major expenses. Second mortgages can also be used to consolidate debt, to reduce interest payments or to avoid the need to pay PMI on your first mortgage. Borrowers are cautioned to avoid using second mortgages for everyday expenses or for paying off outstanding debt without having a clear plan to reduce spending and prevent building more debt. It’s important to remember that you could lose your home if you are not able to make regular loan payments on your first or second mortgage.
The pros and cons of a second mortgage
Take the time to understand the benefits and pitfalls of second mortgages before you make a commitment.
- Available Cash. When you need money, you can get a lump sum from a second mortgage or have a source of credit from a HELOC.
- Ease of qualification. Because the loan is secured by your home, it may be easier to qualify for a second mortgage than for other unsecured loans, such as personal loans.
- Lower interest rates. While a second mortgage is likely to have a higher interest rate than your first mortgage, it is likely to be lower than other alternatives such as personal loans and other unsecured loans.
- Possible tax savings. Depending upon how you are using the loan, interest paid on a second mortgage may be tax deductible, thus reducing your federal and state liabilities. Consult your tax advisor to learn more.
- Risk. Whether your second mortgage is large or small, it uses your home as collateral, meaning your home is at risk if you find that you cannot make payments as scheduled.
- Fees. The mortgage may have some loan origination fees. Include these when you assess whether the loan is a good idea vs. other sources of money. Spread the fees across the amount of money you will borrow to determine the equivalent interest rate they represent. However, some lenders, like Discover Home Loans, do not have application fees, origination fees, appraisal fees, or cash due at closing.
- Monthly payments. Although this is a fairly obvious feature of the loan, it’s important to factor the new amounts for the additional mortgage into your monthly budget to be sure you will have the regular income to pay them. A rule of thumb recommendation is that your total monthly home payment should be less than one-third of your total monthly income before taxes.
- Trading short–term for long-term. If you consolidate debt to get the lower interest rate of a second mortgage, you may end up actually paying more interest if short-term debt at a high rate is included in that consolidation. Be sure to consolidate the right types of debt.
Here are the key differences between a home equity loan, home equity line of credit, and mortgage refinance:
- A home equity loan or a second mortgage is a fixed-amount, fixed-term loan at a fixed or adjustable rate. After your loan is approved you get a lump sum payout and then begin making monthly payments of interest and principal.
- A home equity line of credit (or HELOC) is an open-ended loan that allows you to borrow money when you need it, possibly multiple times, up to your approved credit limit. Once you start making withdrawals, you start making monthly payments toward interest and principal.
- Refinancing your first mortgage is a third option if mortgage interest rates have declined significantly from the time of your original purchase or last refinance.