The phrase itself might be a little confusing: a “second mortgage?” If you already have one loan, why would you want a second?
Well, second mortgages — also known as home equity loans — can be a low-cost form of debt that helps you achieve other financial goals. And in 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?
When people use the term “second mortgage,” they are usually referring to a home equity loan or a home equity line of credit (HELOC).
“A second mortgage is essentially a loan on your property that takes a second position after your main mortgage,” explains Matthew Stratmansenior financial advisor to the California Financial Planning Society, South Bay Planning Group.
Second mortgages, whether a HELOC or a home equity loan, allow homeowners with sufficient equity in their home to borrow against the asset. Equity is the value of your home calculated by subtracting the remaining amount of your loan from the total value of your home.
You can’t always borrow the full amount of your home’s value – experts generally say up to 85% is what banks and lenders allow. For example, if your home is worth $400,000, the maximum amount most borrowers could borrow would be $340,000. But if you have $200,000 left to pay on your main mortgage, that would leave $140,000 of equity to borrow.
Types of second mortgage
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 all at once. Meanwhile, a HELOC works 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 much like your primary mortgage. To qualify, you must provide the lender with all your personal financial information. The lender will assess the value of your home and tell you how much home equity loan you qualify for. Then you can withdraw that sum of money as a lump sum of cash, which would be repaid over a period of 20 or 30 years with interest.
One of the biggest advantages of home equity loans are the low interest rates, Stratman says. Compared to credit cards and personal loans, mortgage rates are generally lower. Therefore, home equity loans can be ideal for home improvement projects that require an upfront lump sum, but could potentially increase the value of your home later.
“The best way to use the equity in your home…would be if you actually use it as something that adds future value to your property,” Stratman says.
Home equity loans are also a great debt consolidation tool, according to Jodi room, president of Nationwide Mortgage Bankers. If you have a fixed amount of debt in the form of student loans or credit cards, you can use the cash lump sum from a home equity loan to pay off the other debt all at once.
“That’s when a home equity loan is better than a home equity line of credit,” says Hall.
There are a few downsides to home equity loans, however. First, they increase your overall debt, which can be risky if you don’t use it wisely or pay it off on time. You also add 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 the money right away.
A HELOC is a form of revolving credit, much like a credit card. You would apply for HELOC the same way you would for a home equity loan, and the lender would give you an upper limit on how much you can spend. Your credit limit will likely reach 85% of the value of your home or less. Lenders consider your credit history and factors like income when assigning your limit.
During the “draw period” you can spend up to your limit. When the draw period is over, you must then start repaying the amount you have used.
“A home equity line of credit is really great if you want to have the availability to access it, but you might not know when you’ll need it,” Stratman says.
HELOCs can be useful if you need to repair 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 good when you’re doing, say, a renovation, where you may need different amounts of money throughout the process,” says Hall.
But be careful not to treat a HELOC too much like a credit card, warns Stratman. The money should be used for productive investments that potentially yield more than what you pay in interest.
Hall agrees: “I would warn people [against] use the equity in the home for their day-to-day expenses,” she says.
Second Mortgage vs Refinance
Home refinancing is another common method of managing large expenses or strengthening your financial footing. Second mortgages are not the same as refinancing. They can both help you save on interest in two different ways.
Refinancing is essentially restarting your main mortgage, often with a lower interest rate or better terms. In contrast, you only save on interest with an arbitrage second mortgage, which means you use the money borrowed from the second mortgage to pay off high-interest debt or buy something you would otherwise use a credit card for. high interest credit.
Sometimes you can access a cash refinance, where you take advantage of the new equity in your home and get a cash lump sum by raising your mortgage closer to its original amount.
“If you need some immediate cash today, this cash refinance could come in handy,” Stratman says. Also, the interest rates on a cash refinance, because it is your main mortgage, are usually lower than the interest rates on a second mortgage.
Refinancing can be more complicated than a second mortgage and usually has higher upfront costs.
Here’s how to compare the differences:
Advantages and disadvantages of a second mortgage
Second mortgages can serve many different purposes, but you should also be aware of some of the risks and shortcomings.
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 long-term value
HELOCs are flexible and you only pay for what you use
Adds to your overall debt amount
Adds another loan payment to your monthly bills
HELOCs, if you’re not careful, can trick you into living beyond your means
Adding a second mortgage payment can be more expensive than simply refinancing your main 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. Installing a new kitchen or adding a new bedroom, for example, are both investments in your home that can significantly increase its value and a solid use of your home equity.
You can also consider a home equity line of credit to prepare for unexpected housing costs. In older homes especially, leaky roofs or old heating systems can eventually lead to costly repairs. Securing a HELOC could give you a way to pay it off with a much lower interest rate than a credit card or personal loan.
“It really provides peace of mind,” says Hall.
Second mortgages are not only useful for real estate investments, they can also be a great way to consolidate other high interest debt.
But real estate investments aren’t the only reasons to consider a second mortgage: “Debt consolidation is one way people put it to good use,” Stratman says.
Here’s how it might work: Let’s say you have a credit card balance of $15,000 with an interest rate of 18%. You could pay off the credit card using money from a second mortgage, which would have a much lower interest rate, and end up saving money in the long run.
Of course, there are also scenarios in which you shouldn’t use a second mortgage, Stratman and Hall said. If you’re having trouble coping with your finances because you’re living beyond your means, a second mortgage will only make the problem worse and increase your debt load. Don’t use the money for a big lifestyle purchase—for example, a boat or a fancy car—that you couldn’t otherwise afford.
“The bottom line is that if you access the money, try to use it as productively as possible without the equity money funding your lifestyle. If used responsibly, it can be a good idea,” says Stratman.