What Is A Second Mortgage And How Does It Work?

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If you’ve been cooped up in your home during COVID-19 quarantines, you may be daydreaming about home improvement projects to spruce up your four walls.  

For homeowners with good credit and significant home equity, a second mortgage may be an attractive — though increasingly difficult-to-get — option for financing that kitchen remodel or pool.

What Is a Second Mortgage?

Also known as a junior lien, a second mortgage is an additional loan taken out against a property that already has a primary loan (the original mortgage). What’s important to know: “[This] second loan can be drawn against the equity or the paid-off balance of the property,” says Miss-Ashley Kendrick, Esq., associate broker and attorney with Maricopa Real Estate Company in Arizona.

The term “second mortgage” refers to a home equity loan or a home equity line of credit (HELOC). They’re often used to consolidate debt, fund home improvement projects, or pay the costs of school, college and other large expenses. This type of mortgage is considered “second” because, in the event of a foreclosure, this lender would be repaid after the primary mortgage holder. 

How Does a Second Mortgage Work?

Second mortgages are secured loans for which your home equity — and by extension your home — are collateral, meaning you could lose your home if you default on payment. They’re attractive for homeowners because they often offer lower interest rates (as low as 3.5% for those with excellent credit) than personal loans and credit cards. “Generally, withdrawing a second mortgage on your property usually results in a slight increase in your monthly payment combined …compared to a traditional personal loan from a financial institute with a much higher interest rate and a much shorter repayment time frame,” Kendrick says. The payments you make on a second mortgage are independent of the original mortgage, so you would have to keep track of separate monthly bills.

There are two main types of second mortgages: a home equity loan (which offers a fixed-rate lump sum to be repaid in a fixed amount of time) and a HELOC (a revolving line of credit that allows you to withdraw funds, in any amount, over a period of time). 

Pro Tip

Interest on second mortgages are tax-deductible if you use the money to improve your home — and if the total loan amount between the original mortgage and second mortgage doesn’t exceed $750,000.

HELOCs and home equity loans have been more difficult to get because of the COVID-19 recession, with lenders pulling back from offering the product because greater financial need presents greater risk for their bottom line. Credit score and documentation requirements have been raised across the board, so you’ll need to be in great financial shape to qualify.

How Does Home Equity Work?

The funds from a second mortgage come directly from how much of your home you own. On a practical level, “home equity is the difference between what’s owed on a mortgage and what the home is currently worth,” Kendrick says.

If your home was purchased at $300,000 and you owe $200,000 on the mortgage, then you have $100,000 equity in your home. People build equity in their homes by making large down payments, continuing to make monthly payments (quicker if the payments are higher than the minimum), and by living in their homes for as long as possible.

Qualifying for a Second Mortgage

To qualify for a second mortgage, you generally need to be employed or have a steady source of income, a good-to-excellent credit score, a low debt-to-income ratio, and an established track record of paying off your debt.

You’ll likely need to meet a particular loan-to-value (LTV) ratio as well, which compares the amount borrowed for the home with the appraised value of the home. “You need a tremendous amount of equity,” says Michael Foguth, president and founder of Foguth Financial Group. Typically, that means 20% equity, or an LTV ratio lower than 80%. The more you’ve paid off the house, the better

Types of Second Mortgages

There are two main types of second mortgages: home equity loans and HELOCs. Both are open-ended forms of credit you can use to fund home renovations, consolidate debt, and pay for college tuition and other uses. And both can be underwritten by banks, credit unions, and online lenders, too.

1. Home equity loan

A home equity loan is a one-time, fixed-rate loan that lets you borrow against the value of your home. You receive a lump sum of cash — usually, up to 85% of your home equity —  to repay at a fixed interest rate over a set period of time. These loans are beneficial for large projects with upfront costs.

Home equity loans tend to come in large denominations (the minimum loan amount for many lenders starts at $10,000 and can go up to $25,000), and you’re often required to pay interest upfront in the form of mortgage points (2% to 5% of the loan amount) during closing. This can bring down your overall APR, but you’ll need to fork over more cash upfront than if you’d borrowed from a HELOC.

Most home equity loans come with 5- to 30-year terms and fixed interest rates. That means, in this low-rate environment, borrowers with good-to-excellent credit scores can lock in rock-bottom rates.

2. Home equity line of credit (HELOC)

A HELOC is a revolving credit line that’s secured by your home as collateral. It allows you to borrow cash based on your home’s equity. Unlike a home equity loan, where the funds are disbursed at one time, you can withdraw money from a HELOC whenever you want, in whatever increment you desire, over a certain period of time (known as a draw period). After the draw period, in which you make small interest-only payments each month, your line of credit enters a repayment period. This period is when you would need to repay all the money you borrowed, with interest.

A HELOC usually offers a variable interest rate, versus the fixed-rate of a home equity loan. Right now, this would work in your favor because HELOC rates are at historic lows (as low as 3.5% for those with excellent credit). But since the draw period and repayment periods are so long, don’t count on your rate staying low forever. 

Second Mortgages: Pros and Cons

Pros

1. Low interest rates (for those with good credit)

Interest rates for mortgages, home equity loans, and HELOCs have dropped dramatically since the beginning of the pandemic. Rates were slashed to near-zero in an emergency move by the Federal Reserve in March. And as a result, many new homebuyers and homeowners are enjoying lower-than-normal monthly payments and rates locked in for the long term. Keep in mind, though: These ultra-low rates are typically reserved for people with excellent credit scores and a lot of equity in their homes.

2. You can borrow a lot of money

With second mortgages, you can usually borrow up to 85% of your home’s equity. Depending on how much of your mortgage is paid off, that can be a large sum. It’s not uncommon for home equity loans and HELOCs to go beyond $100,000 and even $200,000, depending on your LTV ratio, credit score, and borrowing history. In comparison, personal loans and credit cards typically have smaller limits.

Cons

1. More difficult to qualify for right now

Since the COVID-19 recession began, lenders have raised their qualification standards. JPMorgan Chase and Wells Fargo temporarily stopped accepting HELOC applications at the beginning of the pandemic, while others have increased credit score requirements and made the documentation process more stringent. So you’ll likely need a good-to-excellent credit score to qualify for a HELOC or home equity loan now.

2. Your home is the collateral

If you fall behind on payments, you could risk losing your home. Lenders can foreclose on your home if you default, and you’d have to repay not only your original mortgage, but also your second mortgage. Multiple debt obligations can take a toll on your financial health and housing stability. To mitigate this risk, make sure to schedule full and timely payments each month and notify your lender immediately if your financial situation changes. Many lenders can offer relaxed or delayed payment terms, especially if it’s for COVID-19-related hardship — but only if you tell them.

Second Mortgage vs. Cash-Out Refinance

A second mortgage and a cash-out refinance are both common strategies to borrow money using your home as collateral — but there are some key differences.

A cash-out refinance replaces your original mortgage with a new, bigger mortgage, allowing you to receive the difference in cash. It’s also a popular method for debt consolidation and financing home improvement projects, and it doesn’t require you to take out an additional loan (and therefore, make additional monthly payments) the way a second mortgage does.

With a cash-out refinance, you can change the interest rate and terms of your mortgage — and the rates are often lower than a home equity loan or HELOC. A cash-out refinance also tends to be easier to qualify for than a second mortgage, as the lender would be first in line to be paid back in the event of a default. But you’d have to pay more in closing costs since it’s considered a new mortgage.

How to Get a Second Mortgage

1. Determine why you need money — and whether you need another loan

First, figure out your goals. Do you want to replace the roof? Install a pool? Pay off credit card debt? Taking on debt is a big responsibility, and you’ll want to make sure the reason would drastically improve either your finances or your home. 

With any big home renovation project, most homeowners want to increase their home’s value for when it’s eventually resold, in addition to whatever quality-of-life improvements come from it. You’ll have to do the math on whether a remodeled kitchen or a new fence would tick both boxes.

It’s also worth weighing the mortal risks of a second mortgage. If you default on payments, your home could go into foreclosure — and you’d have to pay back not only the mortgage, but also the amount borrowed through the home equity loan or HELOC. 

2. Calculate your home equity 

If you decide to move forward with a second mortgage, you’ll need to figure out how much equity you have. Your home equity directly determines your eligibility for a second mortgage and the amount you’d be able to borrow. Generally, you’ll need to have an LTV ratio of 80% (or at least 20% home equity) or lower to get a home equity loan or HELOC. From there, you can be eligible to borrow up to 85% of available equity, depending on the lender and your financial profile.

3. Shop around 

Second mortgages can be acquired from traditional banks, credit unions, and online lenders so there are plenty of options out there. If you apply for a second mortgage through a bank you’re already with, it may help your chances for approval because you already have a relationship with it and may be eligible for lower rates. You can also go through a mortgage broker or loan originator. 

We recommend getting quotes from at least three different lenders so you can compare interest rates, maximum loan amounts, repayment periods, fees, closing costs, and other factors you’ll want to evaluate before signing a contract. Home equity loans and HELOCs often have terms between 10 and 30 years, so any debt you take out should work for your budget — both now and in the future. 

4. Apply for a second mortgage

Some lenders will allow you to apply for a second mortgage online, while others will require you to go to a bank or credit union branch in person for at least part of the process. This step may also require an appraisal or inspection, which could incur fees around $500, depending on the costs in your area.

The application process will likely ask you for the following information:

  • Social Security number
  • Permanent address
  • Sources of income
  • Employment history
  • Mortgage statement
  • Existing debts and assets
  • Purpose of the loan
  • Co-applicant or cosigner information

The lender will run a hard credit inquiry on you, which means your credit score may be lowered for a short period of time. 

5. Provide documentation

Once you’re approved for the loan or line of credit, you’ll need to provide proof at closing that your application information is correct. The lender will verify this by requesting documentation, which they should provide a list for.

Documents you may need to provide include:

  • Driver’s license or another form of photo identification
  • Proof of Social Security number
  • W-2 forms
  • Pay stubs
  • Tax returns
  • Proof of homeowners insurance
  • If paying off debt: account numbers and balances of loans, credit cards, or other debt

6. Receive funds if you’re approved

Once you’re officially through the closing stage for the second mortgage, you’ll have the choice of receiving the money via check, direct deposit, or wire transfer. It will likely take a few days to a week to receive the disbursed funds. If taking out a home equity loan, we recommend setting up auto-pay through direct deposit, so you’ll never miss a payment.