How Second Mortgages Work

RE Resources Team By RE Resources Team
on February 24, 2017 at 3:49 PM, updated February 24, 2017 at 3:56 PM

A second mortgage can be used to get extra cash if you have equity in your home. While this can be a good tool for some people, it can also be an unnecessary risk for others.

The following explains how second mortgages work so you'll have the information you need to decide if this option is right for you:

Paying the Mortgage

What is a second mortgage?

This type of loan is an additional mortgage on your home. It allows you to borrow money against the value of your home and the equity you have in it, so if you don't make payments on your second mortgage, your lender can foreclose and take your home.

What kinds of loans are available?

Two types of second mortgages are available - a home equity loan and a home equity line of credit (HELOC).

Home equity loans: These are similar to a first mortgage. They can have fixed or adjustable interest rates, with fixed-rate home equity loans generally lasting for relatively long terms, such as 15 or 30 years.

Home equity line of credit: This type of loan has an adjustable rate. It works similar to a credit card, since you can borrow the amount you need up to a maximum limit that's based on your equity. You don't have to ever draw from the line of credit if you don't want to, and it's possible to borrow money multiple times, as long as you don't reach your maximum limit. You can also repay what you borrow and then borrow again.

Why do people use this type of financing?

  • To finance home improvements or repairs
  • To help pay more money toward the down payment on the first home loan to avoid having to pay private mortgage insurance (PMI)
  • To pay off other debt that has a higher interest rate
  • To finance a second home or other real estate
  • To take a vacation
  • To pay for college
  • To pay off medical bills

The best uses for this type of loan aren't short-term, optional purchases. They can help you reduce more costly debt or pay for an investment, but If you're using them for a shopping spree or vacation, this may not be your best financing option. You could potentially put your home at risk for short-term enjoyment.

How much money can you get?

As with a first home loan, it can depend on several factors, including your credit score, income, and overall debt. A lender will also consider how much equity you have in your home and the percentage of your property that's mortgaged. This figure - which is called the loan-to-value ratio - usually can't exceed 75 to 85 percent when first and second mortgages are combined.

What are its advantages?

Potential savings: Even though this type of financing usually has interest rates that are higher than what you'll pay for a first mortgage, they still have a lower interest rate than many other types of debt. If you use your second loan to pay off debt that has a higher interest rate, you should save money.

Flexibility: You're free to use the money you get however you'd like.

Possible tax advantages: In some cases, the interest you pay on this loan may be tax deductible. That's not true of many other types of debt, including credit card debt.

What are some disadvantages?

Cost: This type of loan usually has a higher interest rate than the first mortgage does. It can also have other associated fees, including origination fees, appraisal fees, and closing costs.

Harder to obtain: If you default on your first home loan and your home is foreclosed on, the original loan will be paid off first after the property is sold. Since second mortgage lenders aren't as well protected financially, these types of loans can be harder to get.

More debt with potentially serious consequences: This type of loan puts you in more debt, and it could come with very serious consequences if you can't repay it. The lender could foreclose on your home.

Could cause limitations with your first home loan: If you have a second mortgage, you may have a problem if you want to refinance or modify your original home loan.

A second mortgage is a good financial tool in some - but not all - circumstances. If you're interested in this type of loan, make sure you understand the type of loan you're apply for, what the interest rate is, if this rate is fixed or adjustable, how often it can be changed, how the rate is determined, and if the loan has prepayment penalty. You should also be sure you'll be able to repay the debt, because if you can't, you could ultimately lose your home.