Second Mortgage Loans
If you’re thinking about tapping into your home’s equity for financial needs, a second mortgage might be on your radar. Second mortgages allow you to borrow against your property’s equity while maintaining your current home loan, freeing up funds to use for home improvement projects or other needs.
This article will walk you through the ins and outs of second mortgages, including how they work, qualification criteria, available types, and their usefulness for real estate investors compared to other options like a cash out refinance or personal loan.
What is a Second Mortgage Loan?
A second mortgage loan is a loan secured by your home that is taken out while the original mortgage is still active. Second mortgages allow you to tap into the equity you’ve built into your home by borrowing against that equity.
Like a first mortgage, second mortgage loans are secured by your home, which serves as collateral. A lien is taken out against the part of your home you’ve paid off. If you don’t pay off a second mortgage, your mortgage lender can foreclose on your home.
How do Second Mortgages Work?
To understand how second mortgages loans work, you must first understand home equity:
Home equity meaning: The part of a home you own outright, or the percentage of its value you’ve already paid. Home equity is calculated by taking the value of your home and subtracting your remaining mortgage balance.
As you make your monthly mortgage payments, you steadily build equity in your home: slowly at first as most of your payments go toward interest, but then faster towards the end of your loan. Increasing your home equity can be achieved through property value appreciation or home improvements.
With a typical first mortgage loan, your equity sits untouched in your home until you’ve paid off the entire principal balance. Second mortgages allow you to put this equity to work by borrowing against it. The more equity you have, the more you can potentially borrow.
You apply for a second mortgage similarly to how you applied for your first one. An appraisal is usually needed, and your lender will have specific criteria you’ll need to meet in order to qualify. You will typically need at least 15-20% equity in your home before you can borrow against it. You’ll also need a good credit score (a higher score typically means better rates). Most lenders will allow you to borrow up to 85% of your home’s value minus the debt you currently owe on it.
Funds from a second mortgage loan can be used for anything but are often used for funding home improvement or renovation projects, consolidating high-interest debt, or paying for college tuition.
Note: Taking out a second mortgage loan is different from refinancing. When you refinance, you replace your original loan with an entirely new loan that has a different set of terms, structure, etc. A second mortgage is another loan on top of your primary one that allows you to borrow against your home equity. Homeowners who don’t qualify for a second mortgage can get similar benefits from a cash-out refinance. This option gives you a lump sum of equity in exchange for a new, higher principal. Interest rates for these loans are typically lower than those for than for HELOCs or home equity loans.
Types of Second Mortgages
There are two main types of second mortgages: Home equity loans and Home Equity Lines of Credit (HELOCs). Home equity loans provide a lump sum payment based on equity with fixed repayment terms, while HELOCs work like a credit card with a revolving balance feature.
Home Equity Loans
Home equity loans are most similar to a primary mortgage. You receive the home equity loan as an upfront lump sum and pay it back just as you repay a first mortgage, via fixed monthly installments with interest.
Home equity loans are ideal if you need a lot of cash at once, such as for an expensive home renovation. Many people use home equity loans for ventures that may be otherwise difficult to finance, since the first mortgage is used as a loan for buying that property. However, keep in mind that the rates of home equity loans tend to be a bit higher than those of traditional mortgages.
HELOCs
HELOCs work more like credit cards and provide more flexibility for ongoing expenses. After establishing a home equity line of credit or HELOC, you can borrow funds from your home equity as often as desired and in any amount desired (up to a maximum set by the lender, usually dependent on how much you already owe on the home loan). There’s no lump sum granted. Rather, you borrow, repay, and pay interest on only what you need at a time.
For example, say you have a HELOC with a maximum credit limit of $9,000. If you use $5,000 of that limit on home renovations, you’ll have $4,000 remaining that you could borrow. But as soon as you repay the amount you borrowed, you now have access to the full $9,000 again.
You can use your HELOC during the “draw period” – an established period that the line of credit is active. You must make minimum monthly payments on any amounts you borrow just like a credit card.
At the end of the draw period, the repayment period begins. During the repayment period, you can no longer take out money and must pay off the entire balance left on the HELOC, plus any accrued interest. The length of the repayment period can vary, but it is often around 20 years.
HELOCs are an ideal option if you don’t know how much money you’ll need or if you want funds spread out over a longer period.
It’s important to keep in mind that the 2nd mortgage rates for HELOCs are variable, which means they can rise and fall according to the mortgage index your lender is using. Interest rates for these are typically a bit higher than first mortgage rates. However, HELOCS do generally have higher credit limits than credit cards or personal loans. You may even be able to secure a fixed interest rate. They also tend to have low or no loan origination fees, another benefit of this type of loan.
Understanding the distinctions between these two types of second mortgages can help you choose the one that aligns best with your financial goals and preferences. Consider factors like your borrowing needs, repayment preferences, and financial strategy when deciding between home equity loans and HELOCs.
Qualifying for a Second Mortgage
To qualify for a second mortgage, you’ll need to meet specific financial requirements and demonstrate sufficient home equity. Lenders typically look for the following:
- At least 15-20% of equity in your home
- Minimum credit score of 620
- Debt-to-income ratio below 43%.
These are the general criteria, but you’ll need to consult with your lender to understand the specific criteria of your loan and ensure you meet all the necessary qualifications before applying.
Pros and Cons of Second Mortgages
Second mortgage loans are a great way to put your equity to work and fund a project you might otherwise be unable to afford. However, they do have their downsides. We discuss both below.
Pros
Some advantages of second mortgages include:
- They help you turn home equity into cash.
- They allow you to fund large expenses or projects like major home renovations or other real estate investments.
- Their interest can sometimes be tax deductible.
- 2nd mortgage rates are often lower than credit card interest rates, making them more suitable for debt consolidation.
Cons
Disadvantages of second mortgages include:
- You’ll have to go through the complex application process again.
- You will acquire an additional monthly payment and accrued interest.
- You take on additional risk – if you don’t pay back your second mortgage, your home is at risk, and you could experience foreclosure.
- The loan size is limited by how much equity you’ve built in your home already.
- You’ll have to pay a second round of fees and closing costs for closing on your second mortgage.
- There’s a possibility of not even qualifying for a second mortgage loan if your home doesn’t appraise highly enough or if you haven’t built enough equity in your home yet.
Using Second Mortgages for Real Estate
To utilize a second mortgage for real estate purposes, you need to consider various options and benefits available to you. When looking to buy another house or invest in real estate, second mortgages like a HELOC or a home equity loan can provide the flexibility to leverage existing equity. These options allow you to access funds for a new property and serve as a strategic financial tool for real estate ventures.
However, it’s essential to keep in mind that approval may be impacted by bad credit, and better terms are typically available with higher credit scores. Investors who understand how to effectively manage second mortgages and potential foreclosure risks can make the most out of this financial opportunity.
Conclusion
Second mortgages are an essential component of the homeowner’s and real estate investor’s toolbox. They provide the opportunity to tap into the existing equity you’ve built in your home or property, finance expensive renovations, or pay off high-interest credit card debt. Understanding how these loans work is a good first step toward leveraging all the financial resources available to you as a homeowner or investor.
