Maybe you find yourself wondering, “What is a second mortgage?” or “Should I get a second mortgage?” If those two questions have crossed your mind, chances are you’re a homeowner and you have a need for cash.
Prior to the option for second mortgages, the only way to realize the equity you’d built up in your home from making mortgage payments was to sell your house. Second mortgages shake up the status quo, however, and give homeowners the ability to tap into their equity without the need to sell their homes. This is accomplished through two second mortgage products — home equity loans and home equity lines of credit (HELOCs).
Second mortgages give homeowners the ability to access money for things like debt consolidation, remodeling, unexpected expenses and medical bills.
How does a second mortgage work?
You build up equity as you make payments on your home. Equity is the amount of your home loan that you’ve paid off and is comprised of your down payment and the percentage of your mortgage payments that have been put toward the principal of the loan. If you were to sell your house for the same price you bought it for, you would technically get to keep all of that equity as cash.
What a second mortgage does is gives you the ability to tap into that equity without the need to sell your home. Lenders will give you access to more money based on the fact that you have equity built up in your home. The loan is secured and uses your house as collateral, just like your original mortgage. It’s called a second mortgage because it is the second mortgage you’ve taken out on the same home, and that mortgage lender would be second in line to collect its money if you were to default on the loan.
People take out second mortgages for many reasons. Some of the more popular reasons include things like consolidating debt, paying unexpected medical bills, remodeling or adding on to a home, replacing major appliances or covering emergency expenses.
Types of second mortgages available
The term second mortgage actually refers to two different loan products that are available to homeowners. These two loan products both use your home as collateral but provide funding in a different manner. These are:
- Home equity loans — With a home equity loan, you will get all of your borrowed money upfront as a lump sum. Much like your original mortgage, you will repay this loan with fixed monthly payments right alongside your mortgage payments. Home equity loans are best for projects that require all funds to be available right away, like home improvement products or lump-sum bills.
Approval for a home equity loan requires that you be a homeowner, have good credit and are not carrying too much debt. Additionally, you will need equity in your home. According to the Federal Trade Commission, your borrowing is typically capped at 85% of the equity built up in your home. The cost of a home equity loan will depend on market conditions, your creditworthiness and the lender’s view of your ability to repay.
- Home equity line of credit (HELOC) — A HELOC is a form of second mortgage that does not give you an upfront lump sum of cash. You are given a line of credit instead with a maximum dollar amount you are allowed to spend.
Generally, HELOCs are broken into two periods — the draw period and the repayment period. During the draw period, you are able to use and reuse the funds that you have been approved for. You are able to make payments and continue reusing the funds available during this period if you’d like. At the end of the draw period, you will enter the repayment period, where you will make fixed payments (like with the home equity loan) to pay off the money that you have outstanding.
HELOCs are great for borrowers who don’t know how much money they want to borrow. For example, if you have a home improvement project but aren’t sure of the total cost, a HELOC can protect you from borrowing money you don’t need. The approval qualifications for a HELOC mirror those of a home equity loan.
Pros of a second mortgage
There are many positives that come from using a second mortgage. Regardless of whether you use a home equity loan or a HELOC, you can get the money you need to meet your financial need.
- You can borrow a lot of money. With the ability to borrow, on average, up to 85% of your home’s equity, you can get access to a lot of money that might not be available with other borrowing mechanisms.
- It’s an affordable form of borrowing. The interest rate on a second mortgage may be less expensive than other forms of borrowing you’re looking into.
Cons of a second mortgage
There are risks that come with using a second mortgage. Make sure you fully understand what you’re signing up for before you borrow the funds.
- Your house is collateral. If you default on your second mortgage, you may lose your house, just as you would with your original mortgage.
- There are additional fees. You won’t just be making payments on your loan with a second mortgage. You may also need to pay appraisal costs, origination fees, credit check fees and anything else that the lender requires.
Common uses of a second mortgage
There are plenty of great uses for a second mortgage. The products are designed as a way to give borrowers the flexibility to use their funds how they see fit.
- Debt consolidation — If interest rates have dropped or your financial situation has changed, you may be able to save on other debt by using a second mortgage to consolidate your debt into one lower-priced loan.
- Home improvements — One the most common uses of a second mortgage is to make home improvements, remodel or upgrade part of the home. What’s great about using the funds for home improvements is that it generally adds value to the asset that you’re borrowing against, which means you may recoup some of that money when you sell the home.
- Medical bills — When unexpected medical bills appear, you may need help covering the costs. A second mortgage may be the right solution to get you the funds you need.
- Appliance repair/replacement — When something breaks in your home, you often have no choice but to repair or replace it. A second mortgage may help with higher-priced appliances like HVAC or plumbing.
Tips for getting a second mortgage
- Have the necessary documents prepared ahead of time. Your lender will require a decent amount of paperwork to get your loan approved, and collecting these documents prior to applying will help expedite the process. This includes current loan information, asset documents, income statements and info on what you’re using the loan for.
- Shop multiple lenders. Different lenders will offer different rates and terms on a second mortgage. Take the time to look at online lenders, banks and credit unions to find the most fitting option.
The bottom line
Deciding whether to get a second mortgage depends on what you need the money for, how much equity you have built up in your home and what your long-term financial goals are. Your second mortgage will be something you’re likely to pay on for decades, so don’t take the process lightly. Make sure you have a plan to use the funds wisely and a plan for repayment.