If you already have a mortgage on your home, you may be wondering how a second mortgage works. Sometimes a second mortgage lets you borrow against your home’s value, making it a reasonable alternative to consolidating other debts.
While second mortgages give you flexibility in terms of money on hand, second mortgage rates tend to be higher than traditional titles and come with some risks. It’s important to identify the basics of this popular equity-based loan, so first, let’s define it.
What is a second mortgage?
A second mortgage is a form of loan taken out on top of the mortgage you already have on your home. Second mortgages are also sometimes called home equity loans. When you purchase a home and take out the first mortgage, your home is used as collateral. Over time, as you make payments on your mortgage and your house appreciates in value, you build up equity in your home.
Once you’ve built up enough equity, you can take out a second mortgage that borrows against the equity you now have in your home. Unlike traditional mortgages, used to purchase property, second mortgages typically take the form of a lump sum payment that a borrower receives at the beginning of the loan. When borrowers take out a second mortgage, they must pay back the loan with interest over time.
If you stop making payments on a first mortgage, your lender can seize your collateral. However, if you default on a second mortgage, the lender from the first mortgage still has priority when it comes to getting paid back for the loan. This means that second mortgages are a riskier prospect for lenders. Because of this, not all banks offer second mortgages, and the second mortgages available come with higher rates and fees than a traditional mortgage.
Second mortgages can take a wide variety of different forms:
- Home equity loan: One-time loans can be disbursed to a homeowner as a lump sum based on the equity they’ve built up in their house. This mortgage typically has fixed interest rates, as well as repayment terms.
- A home equity line of credit (HELOC): In this case, homeowners can open up a revolving line of credit based on their home’s equity. If you choose this mortgage, you’re allowed to borrow a maximum limit set by your lender. Like with a credit card, you can access your credit line whenever you need it.
[Related: Home Equity Loans vs HELOC ]
When to get a second mortgage
If you have a significant expense on the horizon and have a good amount of equity already built up in your house, it may be a good time to think about using a second mortgage. Second mortgages represent a significant lump sum of cash that can be used to fund a wide variety of expenses. People often use second mortgages to finance repairs or additions to their home, to pay for their children’s college educations or to consolidate other debt.
You should only take out a second mortgage if you need the money to fund a legitimate expense. While it might be tempting to use the funds from a second mortgage to take a vacation or to buy unnecessary items, this isn’t a wise financial move in the long run. While some borrowers take out second mortgages to invest in other real estate, this can be risky, as the future value of a property isn’t guaranteed.
Common uses of a second mortgage
There are a variety of general uses for a second mortgage. These include:
- Paying down high-interest debt such as credit cards or personal loans, which can save you money in the long run
- Using a second mortgage to finance educational expenses such as college tuition
- Paying unexpected medical bills
- Using a second mortgage to fund necessary repairs on your home
- Conducting a home improvement project, renovation or addition to your home
- Avoiding private mortgage insurance (PMI) by keeping a low-to-value ratio on your primary mortgage
Pros and cons of a second mortgage
Second mortgages come with various benefits, but there are also risks associated with taking out an additional mortgage on your home. Whether or not a second mortgage is right for you depends on your financial situation and how you plan to use the money.
- Has a lower interest rate than many other types of borrowing, and can be used to consolidate higher-interest debt
- Can be used to finance significant expenses such as college tuition or a home renovation
- A second mortgage gives you access to a larger sum than you may otherwise be able to qualify for
- Debt repayments usually last up to 30 years
- Interest rates on a second mortgage tend to be higher than rates for a traditional mortgage
- By using your home as collateral, you run the risk of foreclosure if you find yourself unable to make payments
- Second mortgages can make it more difficult to refinance your original mortgage or to sell your home
- Your properties value could decrease, leaving you “underwater” on your house
Tips for getting a second mortgage
If you’re thinking about applying for a second mortgage, there are a few things to keep in mind during the application process. To apply for a second mortgage, you should:
- Make sure you’ve built up enough equity in your home – Lenders won’t issue you a second mortgage unless you’ve built up a substantial amount of equity. This means that a second mortgage usually isn’t a good choice for borrowers who have only recently purchased a home.
- Check your credit score and raise it if possible – The higher your credit score, the more likely you are to be approved for a second mortgage and secure competitive interest rates when doing so. Check your credit score, and make sure to dispute any errors that may exist on your credit report. If you have poor credit, you may not qualify for a second mortgage.
- Gather relevant information and documents – When you apply for a second mortgage, you’ll need to provide information about your finances and income. Be sure to gather documents, including pay stubs and tax returns beforehand so that the process goes as smoothly as possible.
- Compare different lenders – As with any type of loan, you should be sure to shop around and consider different lenders when it comes to a second mortgage. Comparing different lenders can help to ensure that you get the best price possible.
Too long, didn’t read?
While a second mortgage isn’t for everyone, it can be a smart solution if you’ve built up a substantial amount of equity in your home and have significant expenses on the horizon. However, you should be prudent with this type of financing and reserve it for projects that will benefit either your home value or overall financial wellness. Also, make sure to compare offerings from several different lenders to secure the best terms and interest rates you can.