What Is a Second Mortgage?
A second mortgage is a type of loan that you can get even if you have an existing mortgage that you are still paying off. Second mortgages allow individuals to borrow against the equity that they have already built in their home. HELOCs and home equity loans are types of second mortgages.
What You Should Know
- A second mortgage is a loan that allows you to borrow against the equity of your home
- You will typically need to have at least 20% equity in your home to qualify for a second mortgage
- Second mortgages can come in the form of a one-time lump sum payment or in the form of a line of credit where you can draw the funds when needed
- Second mortgages come with interest rates lower than private loans and credit cards, but their rates are still higher than mortgage rates typically charged for first mortgages
- Home equity loans and HELOCs are examples of second mortgages
What is a Second Mortgage?
A second mortgage is a loan that can be taken out by using the equity you have in your home. The equity you have built is the portion of the house that you have already paid for and do not owe as part of your mortgage. From the name, the mortgage you take to purchase the house is the first mortgage, and consequently the next mortgage taken against the equity is the second mortgage. When you take out a second mortgage, you are putting a lien against the portion of the house that you have already paid off. In other words, that portion is the collateral and in case of default, the lender can use it to make back the amount owed.
In case of home foreclosure, your first mortgage has the priority lien. This means that the first mortgage will need to be paid off first from the proceeds of selling the house and then what is left can be used to cover the second mortgage. Since the lender of the second mortgage faces higher risk as they can only be paid back after the first mortgage has been paid off, they charge slightly higher interest rates on second mortgages and lend smaller amounts.
Forms of Second Mortgages
There are two ways in which you can borrow funds through a second mortgage.
Typically, second mortgages come in the form of a one-time lump-sum payment, which the borrower can use to fund any expense, purchase or project that they want. Once the lump sum is given out, the borrower cannot ask for additional funds from the lender. In order to pay off the loan, they will start making periodic mortgage payments.
|Line of Credit
Some second mortgages come in the form of a line of credit. Through a line of credit, the borrower can borrow funds when and as much as they need to. The lender specifies a maximum borrowing limit that the borrower cannot exceed. Once the borrower uses the line of credit, they will need to pay interest on the amount borrowed. Similar to a credit card, you can borrow and pay back the amount whenever you want to.
Second Mortgage Requirements
Similar to a regular mortgage, the lender will need to verify your income, status of employment, assets and credit history, in order to determine if you have the financial means to pay off a second mortgage. They will need to check your credibility as a borrower and assess the risk of you defaulting on the loan. Some of the criteria the lender will require you to fulfill include:
Home Equity - Simply having some equity in your house is not enough to get a second mortgage. You will typically need to have built more than 20% equity in your home since the first 20% will need to be kept with the first mortgage. Therefore, not all homeowners can qualify for a second mortgage.
Credit Score - You will typically need to have a credit score of at least 620. However, depending on the type of mortgage you apply for and the lender you are working with, the minimum credit score requirement may be higher.
Debt-to-Income Ratio - The DTI ratio shows the portion of your income that is used to pay off any outstanding debt obligations, such as car loan payments, student loan payments, credit card bills, and the mortgage payments, You will typically need to have a maximum debt-to-income ratio of 43% in order to qualify.
DTI Ratio - Example
Imagine that you monthly wage is $5,000 and the following are your debt obligations:
Mortgage payment = $1,234
Car loan payment = $323
Credit card bill = $100
What is your DTI ratio?
Types of Second Mortgages
The most common types of second mortgages include home equity loans and HELOS. Below, we discuss each of them in more detail:
Home equity loans
A home equity loan allows homeowners to borrow against the equity of their home in the form of a lump-sum payment. After this one-time lump sum payment, you cannot borrow more funds from your home equity loan. The lender determines the amount they will lend you depending on the balance you owe on the first mortgage and the Loan-to-Value ratio that the lender permits.
A Home Equity Line of Credit is another type of second mortgage available to homeowners. Similar to a home equity loan, a HELOC allows you to borrow money against the equity in your home. However, while with a home equity loan you can only borrow once, a HELOC is more similar to a credit card. This means that you can borrow as many times, as much and whenever you need to. The interest will be charged only on the amounts borrowed.
HELOCs consist of two periods: the drawing period and the repayment period. The drawing period is the time when the borrower can draw funds from the HELOC as the need arises. During this period you do not have to pay back the principal you owe, you can pay only the interest charged on the borrowed funds. On the other hand, during the repayment period, you can no longer borrow anymore funds from the HELOC. Instead, you are required to pay back the principal just as you would with a regular mortgage, by making monthly mortgage payments.
|Home Equity Loans
How much can I borrow through a second mortgage?
To determine how much you can borrow through a second mortgage, lenders also take into account the amount that you already owe on your first mortgage. Generally, the amount of your first and second mortgage combined should not exceed 90% of the appraised value of your home. To measure this, lenders use the Combined Loan to Value ratio, or CLTV.
CLTV Ratio - Example
Imagine that you own a home with a value of $350,000. However, you still owe $150,000 on the mortgage you used to purchase this house. You are now looking to take out a second mortgage to fund a home renovation project. What is the maximum amount you will be able to borrow through the second mortgage?
You will be able to borrow a maximum of $165,000 if the lender allows a CLTV of 0.9.
Advantages and Disadvantages of Second Mortgages
If you are considering taking out a second mortgage, make sure to first evaluate the advantages and disadvantages that it represents.
Access to untapped equity - Second mortgages allow you to use the equity you have in your home to borrow more money. Depending on the equity you have stored, some lenders may allow you to borrow 90% of that equity. This means that you will be typically able to borrow a whole lot more with a second mortgage than other loans.
Risk of default - Taking out a second mortgage means that you will have to make two mortgage payments every month. This can make your budget very tight and increase the chances of defaulting on your loan. If this happens, you risk losing your home which is being used as collateral.
No restrictions on funds usage - With a second mortgage, the lender doesn’t care what you use the money for, since the collateral will still be the home. Whether you pay off your tuition debt, or buy an expensive car, you can use the funds towards whatever you want.
Higher interest rates than refinancing - In the case of default, the first mortgage will have to be paid off first and what is left can be used to pay off the second mortgage. This means that the lender of the second mortgage takes on more risk. To account for this risk, second mortgages come with higher interest rates. What this means is that if you were to refinance your first mortgage instead of taking out a second mortgage, you would probably get a better interest rate.
Help pay for big expenses - Second mortgages are a great way for homeowners to make renovations or home improvements, which tend to be quite expensive. This way, you will also be creating equity by increasing the value of your home. In the future, you can borrow against this equity.
Costs of second mortgage - Just as with regular mortgages, you will need to pay the closing costs associated with taking out a mortgage. This will include things such as home appraisal, origination fees, credit check, etc. These costs add up quickly and may end up costing you thousands of dollars.
Better interest rates than some loans - Second mortgages tend to charge lower interest rates than private loans and credit cards, making them cheaper than these alternatives.
You may not qualify - In order to get approved for a second mortgage, you will need to have sufficient equity in your home. This usually means more than 20% equity.
How to Get a Second Mortgage?
If you have already taken out a mortgage, the process of getting a second mortgage is pretty straight-forward. Whether you want a HELOC or a home equity loan, the process can be summarized in the following steps:
Step 1: Find a lender
Before you start your search for the lender with the best terms, conditions and rate, make sure to explore the second mortgages offered by the lender who has given you your first mortgage. You have an existing relationship with them, so it might be easier to negotiate terms.
Step 2: Apply for the loan
Depending on the lender you are working with, the application process may slightly differ from one to the other. They will have their own documentation requirements that you will need to fulfill.
Step 3: Gather documentation
Similar to a regular mortgage, you will need to provide proof of your income, employment status, assets and debts, so that the lender can assess your financial standing. The typical required documents include pay stubs, tax returns, bank statements and credit reports.
Step 4: Home appraisal and inspection
The lender may require a second home appraisal to assess the value of your property at the time of application. Sometimes, a home inspection may also be needed.
Step 5: Close on your second mortgage
The final step is to sign the papers at closing, once the lender approves of your second mortgage. You may also have to pay for the fees of services such as home appraisal, title work, if the lender charges you at closing.
Second Mortgage vs Refinancing
Contrary to second mortgages, mortgage refinancing does not lead to the borrower making two mortgage payments every month. Mortgage refinancing is the process of paying off your current mortgage by taking out a bigger one. The bigger mortgage will basically serve to pay off the principal of the existing mortgage and will leave some extra funds for the borrower to use. When you refinance your mortgage, you are basically adding more principal to your current loan. However, the new mortgage may also come with different terms, such as a higher mortgage rate.
The biggest advantage that refinancing has towards second mortgages, is that you will probably get a better mortgage rate. When you refinance, the lender’s lien still has priority over the collateral, therefore they do not assume as much risk as second mortgage lenders. When you take out a second mortgage, the lender of the original mortgage will be paid first, and then the second mortgage lender will be paid if there are remaining funds. In order to account for this risk, second mortgage lenders charge higher mortgage rates.
Should I get a second mortgage or refinance?
Both options present their own set of benefits and drawbacks which you will have to evaluate before making a decision. Whether you choose to take out a second mortgage or refinance your existing one, will also depend on the specifics of your own financial situation.
When should I get a second mortgage?
If you currently pay a relatively low interest rate on your existing loan and the market interest rates are rising, then you wouldn’t want to refinance your mortgage. Refinancing may lead to terms that are less favorable, which is why you should go ahead and take out a second mortgage. A second mortgage may be more expensive in terms of interest rate, however, you will be paying that rate only for the funds borrowed through the second mortgage.
When should I refinance?
If you would like to change the interest rates on your existing loan, then refinancing is preferred. Mortgage refinancing is the best option when the current market interest rates are falling, because you may be able to get a lower rate on the whole remaining principal.
Costs of getting a Second Mortgage
The costs associated with a second mortgage are generally the same as costs to get a regular mortgage. They typically include:
- Origination fees, which are usually 1 to 2% of the loan amount
- Title work and documentation preparation - $200 up to $1000
- Appraisal fee - $300 to $500, although you may not need to pay for this if the lender doesn’t require a new appraisal
- Interest - based on the interest rate charged
What can I use a second mortgage for?
While you can use a second mortgage for pretty much everything you need, it is best to put the funds borrowed towards something that will ultimately increase your net worth. Examples of these types of investments include:
Home Improvement - Investing the money borrowed through a second mortgage to make home renovations and improvements will typically result in an increased value for your home, which will increase your net worth. This is because you will be able to sell the house at a higher price in the future. Undertaking a home improvement project is by far the most common reason why homeowners choose to borrow more funds.
Pay off existing debts - If you have current outstanding debts that you continue paying interest towards, you can pay off the amount by taking one second mortgage as a lump sum. However, there is a risk associated with this technique. A second mortgage is a secured loan, so you would be putting your house on the line if you fail to make the mortgage payments.
Avoid paying for Private Mortgage Insurance (PMI) - With conventional loans, if your Loan-to-Value ratio is less than 80%, then you will have to pay for private mortgage insurance. If you don’t want to pay for PMI, you can get a second mortgage to keep your home equity at 20%. This is sometimes referred to as a piggyback loan.
Education - Second mortgages can provide you with the necessary funds to pay for tuition. However, as we mentioned earlier, it is riskier than a student loan since you would be putting your house on the line if you cannot afford to make the principal and interest payments.
What to consider when getting a second mortgage?
There are a few things you may want to consider when taking out a second mortgage. These include:
How much can you borrow? - Second mortgages allow homeowners to borrow a considerable amount of money based on how much home equity they have. For example, some lenders allow you to borrow up to 80% of your home equity and some even 90%.
How long will it take to get approved? - Just like with a regular mortgage, when you apply for a home equity loan or a HELOC, it will take sometime before you can get approved and have access to the funds. The process will depend on how long it takes for the home appraisal to take place, title search or the time needed to review your application. Sometimes, this can be up to four weeks, and other times, it may be much longer depending on your financial circumstances.
How much will it cost you? - If you take out a second mortgage, you will typically have to pay the loan origination fees, the home appraisal, title search and other closing costs.
Can you afford it? - A second mortgage means that you will be making two mortgage payments every month. This can tighten your budget a lot and not allow you to save in case of emergency. It can be very stressful to live paycheck to paycheck, so you may first want to consider whether you can handle a second mortgage financially.
FAQ - Second Mortgages
Should I get a second mortgage?
Whether you should get a second mortgage or not depends on your specific financial circumstances. However, there are a few things to keep in mind when making that decision. First, a second mortgage would add another mortgage payment to your budget, unlike refinancing, where you just change the terms of the mortgage and pay one, but larger, monthly payment. Second, these mortgages put another lien on your property, which you may end up losing if you don’t make your monthly payments on time. You should consider taking out a second mortgage when what you plan to spend it on will increase your net worth or home value.
How hard is it to get a second mortgage?
Getting a second mortgage is relatively harder than getting your first mortgage. This is because the lender giving out the second mortgage has a secondary lien on your property, as the original lender has the primary one. This means that in the scenario that you default on your loan, the first lender will be paid first, and then the lender of the secondary mortgage will get paid from what is left. For this reason, lenders of second mortgages put stricter restrictions on borrowers, such as a higher credit score.
Can I get a second mortgage if I have bad credit?
Lenders of second mortgages place stricter restrictions on borrowers because they take on more risk than primary lenders. Since lenders of second mortgages get paid only after the initial lenders are paid back, they might also end up not recovering the amount in full. For this reason, they cannot afford to offer a second mortgage to borrowers with bad credit. Bad credit is a measure of how reliable the borrower is in paying back their debt obligations. Typically, you will need to have a credit score of at least 620 or higher to qualify for a second mortgage.
Can I use a second mortgage to buy another house?
Yes. Since there are no restrictions on the usage of a second mortgage, you can use the funds however you wish to. This means that you can also buy another house.
Can I refinance my second mortgage?
Yes. The process of financing your second mortgage is pretty much the same as the process of refinancing your first mortgage.
What is a Silent Second Mortgage?
A silent second mortgage is a mortgage taken out to pay for the down payment of another mortgage. It is called “silent”, because this is not revealed to the lender of the first mortgage.
What happens to the second mortgage if you default on your first mortgage?
If you default on your first mortgage and your home goes into foreclosure, then all the liens on the property will be removed, including that of a second mortgage. However, you will still be liable to pay back the second mortgage, as a separate entity.
How do I not default on my second mortgage?
In order to not default on your second mortgage, you need to make sure that you make the monthly mortgage payment in full and on time. It is important to evaluate your financial situation before taking out a second mortgage so that you better predict your chances of defaulting on the mortgage. However, if you have already taken out a second mortgage, and are finding yourself under challenging financial circumstances, then make sure to contact your lender immediately.
How do I eliminate a second mortgage?
If you regret taking out a second mortgage a few days after getting approved for it, you have three days to cancel it without any penalties. However, if this period passes, you would either have to pay off the balance, refinance it into your first mortgage or declare bankruptcy.