What Are Second Mortgages And How Do They Work?
There are plenty of reasons why you may need access to a large amount of money. Maybe you want to return to school, consolidate a few high credit card balances, or make some repairs to your house. Consider tapping into the equity in your home which is usually much higher than any cash reserves you have. You may be able to use a second mortgage to cover your expenses.
This article will provide you with what you need to know about second mortgages and how they work. Furthermore, we will outline some financing options such as personal loans or cash-out refinances that might be more beneficial to you.
What Is A Second Mortgage?
A second mortgage is a lien taken out on a property that already has a mortgage. A lien is a right to possess and seize property in certain situations.
In other words, if you default on your loan, your lender has the right to seize your home. When you take out a second mortgage , a lien is taken out against the portion of your home you have paid off.
Unlike other types of loans, such as auto loans and student loans, you may use the money from your second mortgage for almost anything. In addition, second mortgages offer lower interest rates than credit cards. It is because of this difference that they are an attractive option when it comes to paying off credit card debt.
How a Second Mortgage Works
So how do you take out a second mortgage? When most people purchase a house or property, they obtain a home loan from a lending institution that uses the property as collateral. It is called a mortgage or more specifically, a first mortgage. The borrower must repay the loan in monthly installments consisting of a portion of the principal amount and interest payments. Over time, if the homeowner keeps up with their monthly payments, the value of their home also increases.
Home equity is the difference between the home's current market value and any remaining mortgage payments. Homeowners may borrow against their home equity to fund other projects or expenses. Since they already have a first mortgage, the loan they take out against their home equity is a second mortgage. A second mortgage is a lump sum payment made to the borrower at the beginning of the loan.
As with first mortgages, second mortgages must be repaid over a specified period at a fixed or variable interest rate depending on the loan agreement. The borrower must pay off the loan before taking out another mortgage against their home equity.
Using a Home Equity Line of Credit (HELOC) as a Second Mortgage
It is not uncommon for borrowers to use a home equity line of credit (HELOC) as a second mortgage. A HELOC is a revolving line of credit secured by the equity in the home. Like a credit card, a HELOC account allows you to borrow up to a pre-determined amount and make monthly payments depending on how much you currently owe.
There will be an increase in the payments as the balance of the loan increases. Generally, HELOCs and second mortgages have lower interest rates than credit cards and unsecured debt. Since a first mortgage is a loan used to purchase property, many people use second mortgages as loans for large purchases that may be very difficult to finance. For instance, people may take on a second mortgage to pay for a child's college expenses or to purchase a new vehicle.
Requirements for a Second Mortgage
You must meet a few financial requirements in order to qualify for a second mortgage. Your credit score must be at least 620. Your debt-to-income ratio must be 43% and above. You also need to have a decent amount of equity in your first home. Since you will be using the equity in your home for the second mortgage, make sure you have enough equity to not only take out the second mortgage but also be able to keep approximately 20% of your home's equity in the first mortgage.
A second mortgage may allow you to borrow a substantial amount of money. Second mortgage loans use your home (presumably a significant asset) as collateral, which means the more equity you have in your home, the better. Most lenders will let you borrow up to 80% of your home's value, and some will even let you borrow more. Additionally, you need to borrow enough money to cover your first and second mortgages.
As with all mortgages, there is a process for obtaining a HELOC or a home equity loan, and the timeline may vary. You will need to request an appraisal of your home, and it typically takes the lender's underwriter a few weeks to review your application. It could be four weeks or longer, depending on your circumstances.
Second Mortgage Costs
As with the purchase mortgage, there are costs associated with taking out a second mortgage. These fees include appraisal fees, credit check fees, and origination fees.
Although most second mortgage lenders claim they never charge closing costs, the borrower still must pay closing costs in some way since the loan amount includes the cost of the second mortgage.
Because a lender in a second position takes on more risk than a lender in a first position, some lenders do not offer second mortgages. Those offering them take extra steps to ensure that the borrower is good to make payments on the loan. When assessing the borrower's application for a home equity loan, the lender will examine whether the property has significant equity in the first mortgage, a high credit score, stable employment history, and a low debt-to-income ratio.
Pros And Cons Of A Second Mortgage
As with any loan, a second mortgage has its pros and cons.
Pros Of A Second Mortgage
- A second mortgage can mean a high loan amount. With a second mortgage, you can borrow up to 90% of the equity in your home. In other words, you can borrow more money with a second mortgage than with other types of loans, especially if you have been paying off your loan for a long time.
- A second mortgage has a lower interest rate than a credit card. A second mortgage is considered secured debt, which means it has collateral (your home). Due to the lower risk of losing money, lenders offer lower rates on second mortgages than on credit cards.
- There are no limitations on fund usage. No laws or regulations dictate how you can use the money you take from your second mortgage. From planning a wedding to paying off college debt, anything is possible.
Cons Of A Second Mortgage
- A second mortgage has a higher interest rate. It is common for second mortgages to have higher interest rates than refinances. It is because lenders do not have as much interest in your home as your primary lender does.
- A second mortgage might put pressure on your budget. By taking out a second mortgage, you agree to make two monthly payments: one to your original lender and another to your secondary lender. This obligation can burden your household finances, especially if you already live paycheck to paycheck.
Second Mortgage FAQs
Learn more about second mortgage loans and their alternatives by reading some of the most common questions borrowers ask when evaluating their financing options.
When should I get a second mortgage?
Second mortgages may not be for everyone but they can make sense in the right situation. The following scenarios make sense for taking out a second mortgage:
- Your credit card debt needs to be settled. Compared to credit cards, second mortgages have lower interest rates. The second mortgage can help you consolidate debt if you have multiple credit card balances on several accounts.
- You need help paying for revolving expenses. Are you in need of revolving credit without refinancing? You can access revolving credit with HELOCs as long as you make your payments on time. You can use this option when you need to cover a home repair bill or tuition on a regular basis.
- Cash-out refinances are not available. Cash-out refinances usually have lower interest rates than home equity loans. However, if your lender rejects your refinance application, you may still be able to get a second mortgage. Be sure to consider all of your options before you take out a second mortgage.
If I have bad credit, should I get a second mortgage?
Although second mortgages can be challenging for people with bad credit, it is not impossible. Obtaining a second mortgage with a low credit score means you will likely be paying higher interest rates or using a co-signer on your loan.
You can also consider finding alternative financing options to help pay for home improvements or debt consolidation. Both personal loans and cash-out refinances are good options if you have trouble qualifying for a second mortgage.
Can I use a refinance to settle my second mortgage?
Taking advantage of a cash-out refinance could help you pay off your second mortgage if you have enough equity in your home. As soon as you pay the secondary lender, you will be back to having a single monthly payment.
Be aware that you must go through the refinance application and appraisal process with your lender. The new loan will also require you to pay origination fees and closing costs. However, you may be able to get a lower interest rate, making this an attractive option for many borrowers.
The Bottom Line: Should You Get A Second Mortgage?
While a second mortgage may seem like the only option to pay off your high-interest debts or fund a significant renovation project, it’s not always the right financial decision. You may be able to find more affordable alternatives if you have a large amount of equity or a good credit score. With a cash-out refinance, you get the flexibility of a second mortgage without the higher interest rate and additional monthly payment. That’s why it’s a good idea to weigh all your options before choosing a second mortgage over a refinance.
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