Also known as a junior-lien loan, a second mortgage refers to a loan obtained using an existing home with a mortgage as collateral. It is referred to as such because if you don't repay your mortgage and your home gets sold off, the initial mortgage receives top priority, and the second mortgage may remain uncleared. That explains why a second home mortgage interest rate is usually higher.
Homeowners can leverage their home equity to get a second mortgage loan, and some examples of these loans include a home equity loan and a home equity line of credit (HELOC).
Second mortgages feature several advantages and drawbacks and may not suit every homeowner. Situations that may warrant an additional mortgage include having credit card debt or revolving expenses that you need access to cash to cover.
A second mortgage refers to a lien obtained against a mortgaged home that has equity. The equity determines how much the second mortgage can be.
Common examples of second mortgages are home equity loans and home equity lines of credit.
Homeowners can use a second mortgage for practically anything, such as to cover revolving expenses or pay off credit card debt.
What Is a Second Mortgage?
A second mortgage is a loan in addition to your first mortgage that’s still ongoing, using your home as collateral. The loan requires a separate application and has a new interest rate, amount, and monthly payment. The amount you can get for a second mortgage is based on your home’s equity. Every lender allows you to borrow up to a specific percentage of your home’s total worth, excluding the amount owed on the initial mortgage.
Second home mortgage requirements may vary based on the lender, but you must have equity as collateral, and you may need to have some cash in reserve in case you cannot repay the loan in the future due to a loss of income. Failure to repay your mortgage means your home may get repossessed to offset the debt.
Homeowners can select from multiple types of second mortgages, either fixed rate or variable rate, depending on the need. Average interest rates for second mortgages are generally higher than the primary home mortgage but lower than credit cards. That may explain why homeowners get second mortgages if they do not qualify for a cash-out refinance on an existing loan.
Some typical uses of a second home loan include consolidating debt, paying for higher education expenses, covering revolving expenses and funding home renovation projects.
How Does a Second Mortgage Work?
The equity of your home can increase if you make lump sum principal payments on your mortgage, make upgrades to your home that increase its value or if valuations in your location go up. Higher equity means you can receive a higher amount from lenders for your second mortgage to meet your financial needs.
Although each lender has a unique combination of requirements for a second mortgage, some standard rules include a maximum of 90% of the appraised market value of your home for both mortgages. Aside from equity, lenders will also consider how much you still need to repay on your primary mortgage. Once you determine the second mortgage amount, you can use MoneyGeek’s mortgage calculator to estimate how much you will pay per month.
The mortgage amount will not be the same as your home's value since lenders spare a percentage to ensure you have some equity left.
Types of Second Mortgages
The equity in your home is the difference between its market value and what you owe a lender on a mortgage. You can unlock the benefits of home equity without selling your home in two major ways: a home equity line of credit (HELOC) and a home equity loan.
Home Equity Loan
Homeowners can get a home equity loan using their property’s equity as collateral. Home equity loans are ideal for homeowners looking for significant funding since they feature a lump sum payment disbursement after the loan closes. Since home equity loans have a fixed interest rate, borrowers make monthly payments of equal amounts for a specific timeframe.
Aside from the market cost of your home, how much you receive for a home equity loan depends on factors like your credit score and income. According to the Federal Trade Commission, most lenders prefer a homeowner to borrow no more than 80% of the home’s equity.
If you face financial challenges and cannot repay your home equity loan, your home may be subject to foreclosure. MoneyGeek advises that you speak to your lender immediately if any such circumstance arises to discuss options for repayment. Failure to pay your mortgage may also result in late fees, extra interest on the owed amount and a lower credit score.
The lender may give you a notice of default as an initial step toward a foreclosure proceeding. While a home equity loan may offer a lower interest rate than an unsecured loan, you risk losing your home should you fail to repay it.
A home equity loan may be a perfect idea if you intend to use the money to increase the value of your home through renovation or home improvement projects or want to pay off high-interest debt since it offers a lower rate than credit cards. This second mortgage type is good if you have a steady source of income to cover the payments, so you do not risk losing your home since its equity is the loan collateral.
Home Equity Line of Credit
Like a home equity loan, a home equity line of credit requires the use of your home as collateral, although it works somewhat like a credit card. You receive a line of credit equal to the equity amount of your home that you can borrow against, but you cannot exceed the limit.
Since a HELOC is secured, homebuyers often may pay a lower interest rate than unsecured options like credit cards and personal loans. Once you get approval from the lender, you can withdraw money multiple times, provided you do not exceed the limit and you make minimum monthly payments on what you have borrowed. When you pay back what you have borrowed, it frees up that money again for use.
HELOCs feature a draw period, which refers to the duration when you can access the money. After this period, you can renew your line of credit or repay the outstanding debt, either in a lump sum or monthly. Unlike home equity loans, most HELOCs have a variable interest rate and do not feature a lump sum upfront payment.
If you have good equity, you can use a HELOC to get money for multiple purposes, including home improvement and debt consolidation. One benefit of a HELOC is the flexibility around borrowing and repayment. You only take as much money as you need and repay the amount borrowed. Borrowers may also enjoy varied tax benefits.
Nonetheless, borrowing against your home puts you at risk of losing it if you default on your HELOC or second mortgage payments. Plus, most lenders require you to pay off your line of credit if you sell your home, reducing what you receive at the time of sale.
HELOCs favor homeowners without clearly defined borrowing needs and those who wish to fund ongoing projects that need access to money over time. This second mortgage type allows you to pay interest on the money borrowed within the draw period, making it ideal for people who do not need a large upfront payout and are disciplined with their spending.
Common Uses of Second Mortgages
Below are some common ways that people use second mortgages.
Upgrading your home may increase its value. A second mortgage makes it possible for you to meet the cost of any home renovations.
A home equity loan can fund a lump-sum payment for educational purposes, while a HELOC may be more favorable for ongoing expenses.
If you have several debts that you wish to consolidate to pay a lower interest rate, a second mortgage offers a good financing option.
Large Medical Bills
A second mortgage can cater to expected or unexpected medical bills. You may use the funds on already incurred medical bills and to cover any future ongoing medical expenses. While it’s best to avoid medical debt, there are other solutions outside of a second mortgage to pay down medical expenses.
Requirements to Get a Second Mortgage
Qualifying for a second mortgage depends on several factors, including your credit score, debt-to-income ratio and home equity.
- Home Equity: According to Experian, approximately 20% equity in your home is required, depending on the lender.
- Good Credit: A credit score of at least 620, although the exact score will depend on the lender — borrowers with lower scores will pay a higher interest rate.
- Debt-to-Income (DTI) Requirement: Meet the debt-to-income ratio requirement of the lender, often less than 43%.
Pros & Cons of a Second Mortgage
While a second mortgage may offer access to money for projects or debt consolidation, it is essential to determine the financial risks associated with getting an additional loan using your home’s equity. MoneyGeek compares the advantages and drawbacks of a second mortgage below.
Pros & Cons of a Second Mortgage
- Lower interest rate: By using your home as security, you may receive a better interest rate than personal loans and credit cards.
- High loan amount: Depending on the lender, you can get more money with a second mortgage than with other loan types.
- Unrestricted funds use: It covers nearly any expense, including education costs.
- Home equity appreciation: By using the money from a second mortgage to improve your home, you may see an increase in its value.
- Risk of foreclosure: If you cannot pay the second mortgage loan, you risk losing your home.
- Higher mortgage interest rate: A second mortgage usually has a higher interest rate than a first mortgage.
- Possibility of unpaid debt: Should you default, the money raised from selling your property covers the first mortgage before the second, leaving you with a potential debt.
- Fees: You will incur closing costs and application fees similar to the first mortgage.
Getting a second mortgage may not be necessary or the best decision, especially if you still owe a lot on your first mortgage or you have not built equity in your home. However, instances that prompt a second mortgage application include the following:
- Major home improvement projects: Some renovations increase the equity or value of your home.
- Unexpected home costs: Parts of your home may need urgent repairs, such as a leaking roof or malfunctioning appliances.
- Purchasing a second home: You may use a second mortgage to purchase an additional home.
- Ongoing projects: Borrowers can consider a HELOC to cover the cost of ongoing projects.
Frequently Asked Questions About Second Mortgages
So, what does it mean to take out a second mortgage? MoneyGeek responds to common questions about this topic to help you through the process.