It’s a particularly tough time to be a homebuyer, but the difficulties in the housing market – like prices that are still well above where they were two years ago – create possibilities for homeowners.
That’s because homeowners are sitting on a lot more equity than they were just a short time ago. The average homeowner gained about $60,200 in equity (the difference between their home’s value and what’s owed on the mortgage) in the past year as of the second quarter of this year, according to the data firm CoreLogic.
Rising mortgage rates, however, have made one option to tapping that home equity far less appealing – the cash-out refinance. Homeowners are less likely to want to give up a favorable interest rate on their first mortgage in exchange for cash. A survey by the home equity platform Point found 35% of homeowners are no longer pursuing a refinance due to rising rates. That has more and more turning to second mortgages, or home equity loans and lines of credit (HELOCs).
If you’re a homeowner and your equity has increased, a second mortgage could be appealing; but is it right for you?
‘Second Mortgage’ Defined
A second mortgage, also known as a junior lien, is a loan that is secured by your home as collateral. The second mortgage is a separate and additional loan relative to your primary mortgage — the one you used to purchase the house.
Second mortgages are very similar to primary mortgages. The difference is in their position of priority if you can’t afford your mortgage payments and the home is sold to pay off your outstanding debt, according to Tabitha Mazzara, director of operations with MBANC, a California-based mortgage lender.
“If something happens and the consumer defaults, the first mortgage takes priority,” Mazzara says. “So it’s a riskier loan for the lender. The credit requirements can be stricter than for someone looking for a first mortgage because with [primary mortgages] the lender is in a better position.”
Because of that higher level of risk, second mortgages tend to have higher interest rates than primary mortgages.
Home equity loans and home equity lines of credit (HELOCs) are commonly referred to as second mortgages because they use the home as collateral and are in second position relative to the primary mortgage.
Common Uses for a Second Mortgage
Second mortgages have few limitations. You can use the money you get through a second mortgage for the following expenses – although it may not be the best way to finance these expenses.
Home equity loans and HELOCs are most commonly used for home renovations, particularly for large remodeling projects that require significant upfront investment.
Because second mortgages come with more favorable interest rates compared to credit cards and personal loans, they are sometimes used to consolidate higher interest debt. Financial experts advise caution when shifting unsecured debt to secured debt, as you risk losing your home if you can’t repay.
Types of Second Mortgages
There are two main forms of second mortgages: home equity loans and HELOCs.
Home Equity Loan
“They’re typically a way to get a lump sum where you can secure an interest rate and borrow a certain loan amount and you repay it back over a fixed number of years,” says Sarah Catherine Gutierrez, a certified financial planner and CEO of Aptus Financial. “They can be great for home remodeling projects, debt consolidation or any case where you know how much you want to borrow.”
Pros and Cons of a Home Equity Loan
There are some advantages and drawbacks to home equity loans to keep in mind.
Because a home equity loan is secured by your house, it usually has lower interest rates than other forms of credit, such as personal loans or credit cards. Your interest rate is fixed, so you have a predictable monthly payment that never changes. And if you use the loan for home renovations, the interest paid on the loan may be tax-deductible.
However, home equity loans are only available to those that have established enough equity in their homes. If you recently bought your house, you may not be eligible.
Because home equity loans give you one sum upfront, you may have to find other financing if your planned project ends up costing more than you expected. Home equity loans also may involve closing costs, which can be 2% to 5% of your loan amount.
Lower interest rates than other forms of credit
Fixed payments and rates
Interest payments may be tax-deductible
One-time lump sum
Significant equity required
Although a HELOC borrows against your home equity, they work very differently from home equity loans. Instead of a lump sum of cash, a HELOC gives you a revolving line of credit.
Pros and Cons of a HELOC
During the HELOC draw period — such as the first 10 years — you can tap into the HELOC again and again. With some HELOCs, you only make payments against the interest during the draw period, so the payments can be quite low, and you only pay interest on the amount of credit you use.
Unlike home equity loans, HELOCs usually have variable interest rates (although some lenders offer fixed-rate HELOCs). With a variable rate, your interest rate can fluctuate over time, causing your monthly payment to change. For borrowers with interest-only HELOCs, in which the payments made during the draw period are only interest, the end of the draw period can cause some shock; your payments will jump to include the principal and interest, and can be significantly more expensive than they were before. HELOCs may have additional fees, such as annual fees, inactivity fees or early termination fees.
Continued access to cash
You only pay interest on what you use
Payments are sometimes lower during the draw period
Usually variable interest rates
Repayment period can come as a surprise
May be additional fees
HELOC vs. Home Equity Loan: Which Is Better?
Neither product is necessarily better for everyone, so consider your own expenses and goals.
If you have an upcoming expense and you know exactly how much money you need — such as ordering new cabinets or consolidating existing debt — a home equity loan may be a good option. You’ll get an upfront sum of cash and have a fixed monthly payment.
If you aren’t sure of that exact cost — or want more flexibility to cover unexpected expenses — a HELOC may be a better choice. You can use the revolving line of credit multiple times, and only pay interest on the amount you use.
Remember, when you take out a second mortgage, you are adding to your overall mortgage debt. That can be risky, Gutierrez says.
“If you get a second mortgage and home values decline, what are you going to do then?” she says. “What if you want to sell your house? You’ll owe more than the home is worth.”
Be sure you can comfortably afford the payments — and can handle losing equity — before taking out a loan.
“For a lot of people, this is not the time to take on new and substantial discretionary expenses,” Guttierrez says.
How Do I Get a Second Mortgage?
If you want to get a second mortgage and apply for either a home equity loan or a HELOC, follow these steps:
- Build equity: Lenders will only allow you to borrow so much equity, with many lenders setting that limit at no more than 80% of the available equity, so it can take some time to build up enough to qualify for a loan or line of credit.
- Review your credit: You generally need good to excellent credit to qualify for a second mortgage. Review your credit reports to make sure the information is correct, and focus on paying down existing debt and making all of your payments on time to increase your credit score.
- Shop for a lender: Rates and terms can vary by lender, so compare offers from multiple banks or credit unions. If possible, request quotes within a limited time frame — such as 15 to 30 days — to minimize the impact on your credit.
- Collect documents: When you apply for a second mortgage, you’ll be asked to provide proof of income, such as your pay stubs or tax returns, recent mortgage statements, and a copy of your homeowners insurance policy.
- Submit an application: Once you submit your application, the lender will review it and perform a hard credit inquiry. The lender wants to ensure you can handle two mortgage payments, so they will also check your debt-to-income ratio.
That’s it! The lender will notify you of their decision and next steps.
Even if you own your home outright — without a mortgage — you can utilize second mortgages to finance major projects. But any home equity loan or HELOC will take first position for repayment.
Second Mortgage Fees and Rates
Second mortgages tend to have higher interest rates than primary mortgages, but they may still be less expensive than other forms of credit.
Interest rates for home equity loans have risen this year alongside the Federal Reserve’s federal funds rate, which has been hiked in response to the highest inflation in 40 years. Rates now average more than 7% for both loans and HELOCs.
Second mortgages can have additional fees. For example, you may have to pay closing costs, which can be 2% to 5% of the loan amount. You may also have to pay early termination fees, annual fees, inactivity fees or make a balloon payment to satisfy the loan.
Frequently Asked Questions (FAQ):
Is there a difference between a second mortgage and home equity loan?
A second mortgage is any loan secured by your home that takes second position to the primary mortgage. A home equity loan is a type of second mortgage. However, a home equity loan can also be utilized if you don’t have an existing mortgage.
“You can get a home equity loan or HELOC whether you have a first mortgage or not,” Mazzara says.
If you own your home outright, you can use a home equity loan to borrow money. In that scenario, the home equity loan is the first mortgage.
Is there a difference between a second mortgage and HELOC?
Similarly, a HELOC can be a type of second mortgage. It is in second position to your existing mortgage, so it is paid only after the primary mortgage is paid in full in the case of a foreclosure. If you don’t have a mortgage, you can use a HELOC to get access to a line of credit, but the HELOC is then in first position.