Rising Home Values Make Second Mortgages More Attractive. Know the Risks Before You Borrow

Second Mortgage vs Home Equity Loan Getty
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Nearly half of mortgaged-American homeowners are considered “equity-rich.” 

Due to home values skyrocketing over the past few years, 48.1% of residential properties with a mortgage and other home loans cover at least half of their value, according to second quarter data from ATTOM, a real estate data firm.

“After 124 consecutive months of home price increases, it’s no surprise that the percentage of equity-rich homes is the highest we’ve ever seen, and that the percentage of seriously underwater loans is the lowest,” Rick Sharga, executive vice president of market intelligence for ATTOM said in the report

In other words, many mortgage holders are in a good position as they hold onto record-high accessible equity. 

The opportunity to borrow against this equity is readily available to many, and many people are considering using second mortgages, home equity loan, or HELOC to finance home renovations, pay for a child’s college education, or consolidate debt. By understanding the nuances of a home equity loan or HELOCs, and what it means to have a second mortgage, you can make an informed borrowing decision.

What Is a Second Mortgage?

“A second mortgage is a lien on your property that is secured behind a first mortgage,” explained Tabitha Mazzara, director of operations for the Mortgage Bank of California

Second mortgages don’t replace your existing home loan; they’re an additional loan you take out and repay separately from the mortgage you used to purchase your house, and your home serves as collateral on the new loan. 

The term “second mortgage” refers to how the loans are handled in cases of foreclosure. If you fall behind on your payments and the house is foreclosed, your house will be sold to pay off the debt. From the proceeds of the sale, your first or primary mortgage — the one you used to buy your house — is satisfied first. If there is any money remaining, it’s applied to the second mortgage. 

If there isn’t enough equity to pay off both loans, the lender of the second mortgage may not get the full amount owed. Because of the risk of not getting fully repaid, lenders typically charge higher interest rates on second mortgages than on primary home loans.

Two common forms of second mortgages are home equity loans and home equity lines of credit (HELOCs)

What Is a Home Equity Loan?

A home equity loan is a type of loan that borrows against the equity you’ve established in your house. 

“In our current climate, it [taking out a home equity loan] is advantageous if someone has a great rate on their first mortgage because they can use a second mortgage to pull out cash to pay for home improvements or pay off existing debt,” said Mazzara. “The second mortgage is a good option if they didn’t want the loan to interfere with the first.”

According to Sarah Catherine Gutierrez, a certified financial planner and the CEO of Aptus Financial, home equity loans may have better rates than other forms of credit. 

“They typically have lower interest rates than personal loans or credit cards because your home is the collateral,” she said. 

As of Aug. 4, 2022, the average interest rate for a home equity loan was 6.38%  By comparison, the average annual percentage rate (APR) for credit cards that assess interest was 16.17%, and the average APR for personal loans was 9.41%. 

Common uses of home equity loans include: 

Is There a Difference Between a Second Mortgage and a Home Equity Loan?

The terms “second mortgage” and “home equity loan” are often used interchangeably, but they’re quite different. 

The term “second mortgage” describes a type of loan and the position it falls in relative to the primary mortgage. A home equity loan can be a type of a second mortgage, but you can also utilize a home equity loan if you no longer have a mortgage and own your home outright. 

“If you own a home free and clear of liens, the home equity loan or line of credit takes first position,” said Mazzara. 

Pro Tip

If you’re shopping for a second mortgage or home equity loan, request quotes within a limited time frame, such as 30 days, to minimize the impact to your credit score.

Pros and Cons of Home Equity Loans as a Second Mortgage

With a second mortgage or home equity loan, you can usually access a larger sum of cash for your goals. Especially if you have established a significant amount of equity in your home. 

Because second mortgages and home equity loans are secured by your house, they typically have lower interest rates than other options. And, you can have 20 years or more to repay them, making the payments more manageable. As an added bonus, the interest paid on the loan may be tax deductible if you use the money for eligible home repairs. 

However, second mortgages and home equity loans aren’t for everyone. 

“They [second mortgages] can be very risky, for several reasons,” cautioned Gutierrez.

Unlike personal loans, home equity loans can take much longer to process, so they’re not always helpful if you have an unexpected emergency expense. And depending on the lender, you may have to pay closing costs — which can cost thousands — to take out a second mortgage. 

For those that are risk averse, using a home as collateral may be too risky since there’s the potential for foreclosure if you fall behind on your payments. And by tapping into your home’s equity, you increase your overall debt, so it will take longer before you’re mortgage-free. 

“Generally though, why would you want to tack more years onto your mortgage?” asked Gutierrez. “Especially as you near retirement, a house payment makes it hard to stop working. Don’t add a burden to what already may seem like an impossible task.”

Pros

  • You may qualify for a larger loan amount 

  • Second mortgages typically have lower interest rates than other forms of credit

  • Second mortgages and home equity loans have longer repayment terms than other options

  • You may be eligible for tax deductions

Cons

  • There is a risk of losing your home in foreclosure 

  • It can take a long time to rebuild equity

  • Second mortgages and home equity loans can take several weeks to process

  • You may be responsible for closing costs

Home Equity Loan vs HELOC

Although home equity loans are what most people think of when discussing second mortgages, there is another option: HELOCs

Like home equity loans, HELOCs allow you to borrow against the equity you established in your home. But while home equity loans give you one-time access to a lump sum of cash, HELOCs are a form of revolving credit. 

“HELOCs make a line of credit available to you,” said Gutierrez. “They tend to have variable rates, though there are some fixed-rate HELOCs out there. You operate under this agreement and can take out money when you need it.”

During the HELOC draw period —often 10 years — you can use the HELOC repeatedly, up to the maximum you were approved for, making it a good option for expenses without a fixed cost or to have as a backup safety net. 

At the end of the draw period, your HELOC enters repayment, which can last from five to 20 years. HELOCs usually have variable interest rates rather than fixed, so the rate can fluctuate a great deal. However, you only pay interest on the funds you use. 

Although HELOCs can be appealing, be aware that their availability can be limited if the economy worsens and banks tighten access to credit or if your equity goes down. Because they may not be accessible when you need it, Gutierrez said they’re not a reliable source of financing for unexpected expenses and shouldn’t replace your emergency fund. 

“Imagine if your home value declines … then you will be left without an option [for emergencies],” Gutierrez said.

Second Mortgage vs Home Equity Loan Vs HELOC: Which Is Better for You? 

If you’re considering taking out a second mortgage and are thinking about a home equity loan or HELOC, carefully consider the pros and cons. Whether it’s a good idea is dependent on several factors, including your overall financial situation, planned uses for the second mortgage, and whether you’ll need ongoing access to credit. 

Before applying for a second mortgage like a home equity loan or HELOC, review all of your financing options. In some cases, it may be a better idea to save money for several months than take out a loan or line of credit. 

“I think people should work on cash management systems and save for planned expenses and unexpected emergencies, then use home equity if needed,” said Gutierrez. “I think home equity can be an okay second line of defense.”

If you do decide to borrow against your equity, request quotes from multiple home equity lenders to find the best terms and rates available. 

How to Calculate Your Home Equity

The amount you can borrow is dependent on your income, credit, and the current value of your home. In general, the maximum you can borrow is up to 80% of the available equity, or the current value of your home minus what you owe on the mortgage otherwise known as loan-to-value ratio (LTV).

To find out how much you can borrow, follow these steps: 

  1. Identify your home’s current value. Popular sites such as Zillow or Redfin have a home-price estimator. They are not the most accurate, experts warn, but they can give you a ballpark figure. 

For this example, let’s say the home is worth $400,000.

  1. Determine your mortgage balance amount.

For this example, let’s say $200,000 is left on the loan. 

  1. Figure out how much equity you are working with by subtracting the balance from the house value. 

$400,000 – $200,000 = $200,000. (50% equity).

  1. Find out what the maximum percentage of the home value your lender allows to borrow (maximum LTV). 

For example, some lenders offer up to 80% LTV and some up to 90% LTV. We will use 80% LTV for this example. 

  1. Multiply your home’s current value by the maximum LTV% 

$400,000 x 0.80 (80%)=$320,000

  1. Subtract the loan balance to get the maximum allowable to borrow amount.

$320,000 – $200,000 = $120,000

Home Current Value$400,000
Mortgage Balance$200,000
Home equity estimate$200,000 (50% equity)
LTV Ratio (before home equity loan)50%
Maximum LTV From Lender (including home equity loan)80%
Maximum allowable to Borrow (0.80 x $400,000)320,000
Maximum borrowing amount $120,000

Based on this example, the homeowner can borrow up to $120,000 with a home equity loan or HELOC. As you can see, you can potentially access a much larger stash of cash with a home equity loan than you could with some other financing options, such as a personal loan.