The phrase itself might be a bit of a turn-off: A “second mortgage?” If you’ve already got one loan, why would you want a second one?
Well, second mortgages — also known as home equity loans — can be a low-cost form of debt that helps you accomplish other financial goals. And at a time when interest rates are historically low and home equity is rising rapidly, it may be worth considering what a second mortgage can do for you.
What Is a Second Mortgage and How Does It Work?
“A second mortgage is essentially a loan on your property that takes a second position after your primary mortgage,” says Matthew Stratman, lead financial advisor at California’s financial planning firm, South Bay Planning Group.
Second mortgages, whether a HELOC or home equity loan, allow homeowners with enough equity in their homes to borrow against the asset. Equity is the value of your home calculated by subtracting your remaining loan amount from the total value of your home.
You can’t always borrow the total amount of your home’s value—experts commonly say only up to 85% is what banks and lenders allow. For instance, if your home is worth $400,000, the maximum amount most borrowers could take out as a loan would be $340,000. But if you have $200,000 left to pay on your primary mortgage, that would leave $140,000 of equity left to borrow.
Types of Second Mortgages
There are two main types of second mortgages: A home equity loan or a home equity line of credit (HELOC). A home equity loan allows you to borrow a lump sum of money all at once. Meanwhile, a HELOC functions more like a credit card, allowing you to spend the balance up or down and only pay for what you use.
Here’s a more detailed breakdown of how each type of second mortgage works.
Home Equity Loan
A home equity loan works a lot like your primary mortgage. To qualify for one, you have to provide the lender with all of your personal financial information. The lender will assess the value of your home and tell you how much of a home equity loan you qualify for. Then, you’re able to take out that amount of money as a lump sum of cash, which would be paid back over a 20- or 30-year period with interest.
One of the biggest benefits of home equity loans are the low interest rates, says Stratman. Compared to credit cards and personal loans, mortgage lending rates are typically lower. Therefore, home equity loans can be a great fit for home renovation projects that require a lump-sum upfront but could potentially increase your home’s value down the road.
“The best way to use equity in your house … would be if you’re actually using it as something that adds future value to your property,” Stratman says.
Home equity loans are also a great tool for debt consolidation, says Jodi Hall, president at Nationwide Mortgage Bankers. If you have a set amount of debt in the form of student loans or credit cards, you can use the lump sum of cash from a home equity loan to pay off the other debt all at once.
“That’s when a home equity loan is more favorable than a home equity line of credit,” Hall says.
There are, however, some drawbacks to home equity loans. First off, they add to your overall debt load, which can be risky if you don’t use it wisely or pay it back on time. You’re also adding a second loan payment to your monthly bills. And, when you take out a home equity loan, you automatically start making payments on the entire balance, even if you don’t spend all of the money right away.
A HELOC is a form of revolving credit, sort of like a credit card. You would apply for a HELOC the same way you do for a home equity loan, and the lender would give you an upper limit of how much you can spend. Your credit limit will likely max out at 85% of your home’s value or less. Lenders take your credit history and factors like income into consideration when assigning your limit.
During the “draw period,” you are able to spend up to your limit. When the draw period is over, you’re then required to start paying back whatever amount you used.
“A home equity line of credit is really good if you want to have the availability to access it, but you might not know when you’re going to need it,” Stratman says.
HELOCs might come in handy if you need to fix an emergency roof leak, for example. But they can also be a good tool for larger, planned home renovations.
“Home equity lines of credit are positive when you’re doing, say, a remodel, where you may need different amounts of money throughout the process,” Hall says.
But be careful not to treat a HELOC too much like a credit card, cautions Stratman. The money should be used for productive investments that potentially give back more than you pay on interest.
Hall agrees: “I would caution people [against] using the equity in the home for their day to day living expenses,” she says.
Second Mortgage vs. Refinance
Home refinancing is another common method of managing major expenses or shoring up your financial foundation. Second mortgages are not the same thing as refinancing. They both can help you save on interest in two different ways.
Refinancing is when you essentially restart your primary mortgage — often with a lower interest rate or better terms. In contrast, you only save on interest with a second mortgage by arbitrage, meaning you use the money borrowed from the second mortgage to pay off high-interest debt or buy something you would have otherwise used a high-interest credit card for.
Sometimes, you can access a cash-out refinance, where you take advantage of new equity in your home and get a lump sum of cash by increasing your mortgage loan closer to its original amount.
“If you have an immediate need for the money today, that cash-out refinance could serve a purpose,” Stratman says. Plus, the interest rates on a cash-out refinance, because it involves your primary mortgage, are usually lower than interest rates on a second mortgage.
Refinancing can be more involved than a second mortgage and usually has more upfront costs.
Here is how to compare the differences:
|Comparison point||Second Mortgage||Refinance|
|Interest rates||Usually in the 4-5% range||Can be lower, in the 3% range|
|Type of funding||Lump sum or credit line||Lump sum of cash|
|Upfront costs||Low or sometimes free with promotions from lenders||Closing costs in the thousands|
|Payback period||As short as 15-20 years||As long as 20-30 years|
Pros and Cons of a Second Mortgage
Second mortgages can serve a lot of different purposes, but you should be aware of some of the risks and shortcomings, too.
Lower interest rates than other forms of debt, like credit cards or personal loans
Can allow you to invest in your home and create more value in the long term
HELOCs are flexible, and you only pay for what you use
Adds to your overall amount of debt
Adds another loan payment to your monthly bills
HELOCs, if you’re not careful, can tempt you to live beyond your means
Adding a second mortgage payment might be more expensive than simply doing a cash-out refi of your primary mortgage
When Should You Consider A Second Mortgage?
One of the best times to consider a second mortgage, Stratman says, is if you’re planning a major home renovation. Putting in a new kitchen or adding a new bedroom, for example, are both investments in your home that are likely to significantly increase its value and are a solid use of your home equity.
You might also consider a home equity line of credit to prepare for unexpected housing costs. In older homes especially, leaky roofs or old heating systems might eventually lead to costly repairs. Securing a HELOC could give you a way to pay for it with a much lower interest rate than a credit card or personal loan.
“It really does offer peace of mind,” Hall says.
Second mortgages aren’t only useful for home investments — they can also be a great way to consolidate other high-interest debts.
But home investments are not the only reasons to consider a second mortgage: “Debt consolidation is one way people can use it wisely,” Stratman says.
Here’s how that might work: Let’s say you have a credit card balance of $15,000 with an 18% interest rate. You could pay off the credit card using money from a second mortgage, which would have a significantly lower interest rate, and end up saving money in the long run.
To be sure, there are also some scenarios when you shouldn’t be using a second mortgage, Stratman and Hall said. If you’re struggling to keep up with your finances because you are living beyond your means, a second mortgage will only compound the problem and add to your debt load. Don’t use the money for a big lifestyle purchase — say, a boat or a fancy car — that you wouldn’t be able to afford otherwise.
“The main thing is, if you are accessing the money, try to use it as productively as possible without having the money from the equity finance your lifestyle. If it’s responsibly used, it can be a good idea,” Stratman says.