What Is A Second Mortgage And How Does It Work?

When you need access to a large amount of money, tapping into your home’s equity, which is usually much larger than any cash reserves you have on hand, may be a viable option for many homeowners.

Before you do, however, you’ll want to learn more about second mortgages and how they work. It may also be wise to explore other financing alternatives that could be better choices for you.

What Is A Second Mortgage?

A second mortgage is a lien taken out against a property that already has a home loan on it. In other words, your lender has the right to take control of your home if you default on your loan. When you take out a second mortgage, a lien is taken out against the portion of your home that you’ve paid off.

Unlike other types of loans, such as auto loans or student loans, you can freely use the money from your second mortgage. Second mortgages also offer interest rates that are much lower than credit cards. This difference makes them an appealing choice for consolidating credit card debt.

Second Mortgage Vs. Refinance

A second mortgage is different from a refinance. When you take out a second mortgage, you must pay your original mortgage as well as another payment to the second lender. On the other hand, when you refinance, you pay off your original loan and replace it with a new set of loan terms from your original lender. You make only one payment a month with a refinance.

When your lender refinances a mortgage, they know that there’s already a lien on the property, which they can take as collateral if you don’t pay your loan. Lenders who take a second mortgage don’t have the same guarantee.

How Does A Second Mortgage Work?

A second mortgage allows you to use your home’s equity to your advantage. With that money no longer tied up in your home, it’s available for immediate expenses.

What Do You Need To Get A Second Mortgage?

Specific requirements for getting approved for a second mortgage will depend on the lender you work with. That said, there are some general requirements that all lenders will require you to meet.

Home Equity

The most basic requirement for a second mortgage is that you have some equity built up in your home. As you pay off your principal loan balance over time, the portion of the loan that you have paid off is called equity.

Your home equity can also increase in other ways. If you’re in a growing real estate area or you make improvements on your home, the market value of your home goes up. This change increases your equity without extra payments. On the other hand, if the value of your home goes down and you enter a buyer’s market, you may lose equity.

Your lender will likely only allow you to take out a portion of this equity, depending on what your home is worth and your remaining loan balance on your first mortgage, so that you still have a certain amount of equity left in your home (usually 20% of your home’s value).

Credit Score And Financial Requirements

To be approved for a second mortgage, you’ll likely need a credit score of at least 620, though individual lender requirements may be higher. Plus, remember that higher scores correlate with better rates. You’ll also probably need to have a debt-to-income ratio (DTI) that’s lower than 43%, though many lenders have stricter requirements.

Although second mortgages are often difficult to qualify for with bad credit, it’s not impossible. Obtaining a second mortgage with a low credit score likely means that you pay higher interest rates or use a co-signer on your loan.

You can also consider looking into alternative financing options to help pay for your home improvements or debt consolidation. Both personal loans and cash-out refinances are good options to use if you have trouble qualifying for a second mortgage.

Types Of Second Mortgages

There are two major types of second mortgages you can choose from: a home equity loan or a home equity line of credit (HELOC).

Home Equity Loan

A home equity loan allows you to take a lump-sum payment from your equity. When you take out a home equity loan, your second mortgage provider gives you a percentage of your equity in cash.

In exchange, the lender gets a second lien on your property. You pay the loan back in monthly installments with interest, just like your original mortgage. Most home equity loan terms range from 5 to 30 years, which means that you pay them back over that set time frame.

Home Equity Line Of Credit

Home equity lines of credit, or HELOCs, don’t give you money in a single lump sum. Instead, they work more like a credit card. Your lender approves you for a line of credit based on the amount of equity you have in your home. Then, you can borrow against the credit the lender extends to you. Rocket Mortgage^® doesn’t offer HELOCs at this time.

Like a credit card, HELOCs use a revolving balance. This feature means that you can use the money on your credit line multiple times as long as you pay it back. For example, if your lender approves you for a $10,000 HELOC, you spend $5,000 and pay it back. Then, you can use the full $10,000 again in the future.

HELOCs are only valid for a predetermined amount of time called a “draw period.” You must make minimum monthly payments during your draw period as you do on a credit card. Once your draw period ends, you must repay the entire balance left on your loan, either in a single lump sum or in payments over a period of time.

Second Mortgage Rates

Rates for second mortgages tend to be higher than the rate you’d get on a primary mortgage. This is because second mortgages are riskier for the lender – as the first mortgage takes priority in getting paid off in the event of a foreclosure.

However, second mortgage rates can be more attractive than some other alternatives. If you’re considering getting a second mortgage to pay down credit card debt, for example, this can be a financially savvy move, since credit card rates are typically higher than what you’d get with a home equity loan or HELOC.

Pros Of A Second Mortgage Loan

Like any other type of loan, second mortgages have both pros and cons to them. Here are some pros to consider.

You Can Potentially Borrow A Large Amount Of Cash

Second mortgages can mean high loan amounts. Some lenders allow you to take up to 90% of your home’s equity in a second mortgage. This means that you can borrow more money with a second mortgage than with other types of loans, especially if you’ve been making payments on your loan for a long time.

They Have More Favorable Interest Rates Than Credit Cards

Second mortgages have lower interest rates than credit cards. Second mortgages are considered secured debt, which means that they have collateral behind them (your home). Lenders offer lower rates on second mortgages than credit cards because there’s less of a risk that the lender will lose money.

They Can Be Used For Anything

With a second mortgage, there are no laws or rules that dictate how you can use the money you take from your second mortgage. That said, you should ensure you have a purpose for the cash you receive from your second mortgage as it’s a big financial commitment.

Cons Of A Second Mortgage Loan

Before taking out a second mortgage, consider the following cons.

They Have Higher Interest Rates Than Refinances 

As mentioned, this is because lenders don’t have as much interest in your home as your primary lender does. The higher interest rates help to offset the risk of lending.

You’ll Have Two Mortgage Payments

Second mortgages might put pressure on your budget. When you take out a second mortgage, you agree to make two monthly mortgage payments: one to your original lender and another to your secondary lender. This obligation can strain your household finances, especially if you’re already living paycheck to paycheck.

When Should You Get A Second Mortgage?

Second mortgages aren’t for everyone, but they can make sense in the right scenario. Here are some of the situations in which it makes sense to take out a second mortgage:

• You need to consolidate credit card debt. Second mortgages have lower interest rates than credit cards. If you have many credit card balances spread across multiple accounts, a second mortgage can help you consolidate your debt.
• You need help covering revolving expenses. Do you need revolving credit without refinancing? If you’re choosing between a refinance and a HELOC, the latter can give you access to revolving credit, as long as you keep up with your payments. This option can be more manageable if you’re covering a home repair bill or tuition on a periodic basis.
• You can’t get a cash-out refinance. Cash-out refinances, compared to home equity loans, usually have lower interest rates. But if your lender rejects you for a refinance, you may still be able to get a second mortgage. Consider all of your options before you get a second mortgage.

The Bottom Line: A Second Mortgage Could Be Right For You

While a second mortgage may seem like the only option to pay down your high-interest debts or fund an important renovation project, it’s not always the best financial decision. If you have a large amount of equity or a good credit score, there might be more affordable alternatives available. A cash-out refinance can give you the flexibility of a second mortgage without the higher interest rate and additional monthly payment.

If you’re ready to access your equity with a cash-out refinance or home equity loan, start exploring your options today.