The Ins and Outs of Second Mortgages and How They Work

It’s no secret that property values have been soaring in recent years. Even though the real estate market has cooled off a little since 2022, you may be living in a home with a lot of equity. The term “equity” refers to the difference between your property’s current market value and the outstanding balance on your mortgage. For example, if your house is worth $100K and the balance of your mortgage is $80K, then you have $20K in equity.   If it’s at your disposal, it’s a shame not to put that money to use for you when you need it.

However, refinancing your existing mortgage in order to “cash out” those funds may not sound ideal right now. Interest rates are at the highest they’ve been in decades, so most homeowners are understandably reluctant to go that route, knowing that they’re looking at an interest rate that could cost them thousands more over the lifetime of their mortgage than what they’re paying now.

A second mortgage might be a better option. 

Second mortgages can allow you to tap into your home’s equity by creating a subordinate loan with its own interest rate and payment schedule using your home’s equity as its collateral. This leaves your existing mortgage (and its lower interest rate) intact.

It also means, of course, that you have two monthly mortgage payments. Default on either and the lender can take action – potentially all the way up to foreclosure – to try to extinguish the debt.

What Are the Different Types of Second Mortgages?

Home equity loans and home equity lines of credit (HELOCs) are the two main types of second mortgages available. Let’s take a closer look at each:

• Home Equity Loans: With a home equity loan, you receive a lump sum of money that you repay over a set period of time, typically at a fixed interest rate. This can be advantageous for those who need a specific amount of money for a single large expense, like a bathroom renovation project or a child’s wedding. 
• Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit that you can draw from as needed up to a predetermined credit limit. The interest rates on HELOCs are often variable, and you only pay interest on the amount you’ve withdrawn. This flexibility is ideal for ongoing expenses or projects with fluctuating costs, such as a whole-house renovation or funding a new business.

Qualification requirements for home equity loans and HELOCs can vary by lender, and you’re under no obligation to seek one from the same lender that holds your current, or “primary,” mortgage. Most lenders do have minimum credit score requirements (usually 600 or better) and your debt-to-income ratio should be at 43% or less. 

Also, don’t expect to squeeze every drop of equity out of your home at once. Lenders still want you to keep a 15% to 20% equity “cushion” in your home minus the balance on both mortgages. That means, for example, if your home is currently worth $400,000 and you owe $200,000 on your current mortgage, you have $200,000 in equity. A second mortgage could allow you to borrow between $120,000 and $140,000.

Why Do People Consider Second Mortgages?

The reality is that a lot of homeowners have more money in home equity than they have funds in their bank accounts. There are all kinds of situations where it simply makes sense to put that money go to work for them. 

Some of the most common reasons for taking a second mortgage include:

• Home Improvements: This is a great reason to take a second mortgage because renovations and repairs can not only enhance your living space but also further increase your home’s overall market value.
• Debt Consolidation: People with high-interest debts, such as credit card debts or personal loans, might choose to consolidate their debts by taking out a second mortgage at a lower interest rate. Consolidating debt can actually leave you with more money in your pocket each month and improve your credit rating.
• Education Expenses: Second mortgages can be used to cover the costs of education, whether it’s funding a child’s college tuition or pursuing your own advanced degree.
• Emergency Expenses: When unexpected medical bills or other financial emergencies arise, a second mortgage can provide a quick source of funds and save the day.
• Investment Opportunities: A second mortgage can allow you to invest your equity in a business or take advantage of other opportunities that could yield a much higher return on your investment than your property alone ever could.
• Buying a Second Home: It isn’t at all unusual for homeowners to use the equity in their primary home to make a downpayment on a second home while they sell the first – or just when they’re buying a vacation home.

Because second mortgages are secured loans, they typically have lower interest rates and higher allowable amounts when compared to personal loans. They also offer a lot of versatility of use – although some lenders may put some restrictions on the funds, which is something you need to investigate as you look for the right lender for your needs.

Is a Second Mortgage Right for You?

While they come with benefits such as lower interest rates and potential tax advantages, second mortgages also carry certain risks, including an increased debt load and the possibility of foreclosure. Just the same, second mortgages are a relatively low-risk way to borrow large sums of cash if you have both a lot of equity and a reliable income – particularly if your intended use will benefit you in the long run.

Careful consideration, thorough research, and professional guidance are essential before committing to a second mortgage. As with any financial decision, the key lies in aligning this option with your long-term financial goals and overall stability.