A second mortgage is a type of home loan that a lender approves in addition to an original mortgage that has not yet been paid in full. Homeowners can use a second mortgage to borrow against the equity they have in their houses, often at lower rates than other types of financing. Essentially, a second mortgage is a lien that’s taken against a house when a new loan is issued and a first loan is still outstanding.
Second mortgages are separate loans that have their own applications, closing costs, and monthly payments, and they enable homeowners to borrow against the equity in their homes without having to refinance the first mortgage. To use a second mortgage, you borrow up to 85 percent of your total home value (minus the amount owed on a first mortgage) for as little as 2 percentage points over the prime rate, plus closing costs. Keep in mind that lenders expect you to have about 20 percent equity in your home before they’ll approve a second mortgage.
How does a second mortgage work?
Second mortgages require a separate application process, underwriting, loan closing, and separate monthly payments in addition to your normal mortgage payments. When a lender gives you a second mortgage, the lender takes a lien against your property that is subordinate to your first mortgage. If you later default on either of your mortgages and one of your lenders has to foreclose, the lender that issued your first mortgage will get paid before the issuer of the second. The structure makes second mortgages riskier for lenders, so rates typically are higher.
Here’s an example:
If you purchase a house for $200,000, make the recommended 20 percent down payment of $40,000 and borrow $160,000, you will wind up paying down your loan over several years to reach a balance of $120,000. If you want to use a second mortgage to renovate part of your home by borrowing against your home’s equity, most lenders will let you borrow up to 85 percent of a property’s value. Because you bought your house a few years ago, your lender will require a new appraisal.
The appraiser estimates the value of the home to be $210,000, so subtracting your balance of $120,000, that means you now have $90,000 in equity in your home. Assuming you have good credit and sufficient income to cover the cost of your loan, you may be able to borrow up to $76,500 using a second mortgage. After closing on your loan, your lender will file a lien against your property, similar to your first mortgage. However, this is a separate loan, with its own lien and monthly payments.
Types of second mortgages
Second mortgages generally fall into one of two categories: home equity loans and home equity lines of credit. With a home equity loan, all of the loan funds are provided upfront in one lump sum. The borrower then makes equal monthly payments consisting of both principal and interest until the loan is paid off at the end of the term. This type of loan comes with a fixed rate. Home equity lines of credit (HELOCs) allow lenders to take a lien against the property upfront, but the borrower has the option of borrowing available funds overtime when needed.
The borrower then makes regular monthly payments that usually are interest-only during what’s called the draw period, about 10 years. When the draw period ends, the repayment period begins, and the borrower must make monthly principal and interest payments. This type of loan comes with a variable rate.
What are the costs of a second mortgage?
Second mortgages have upfront costs that often total 2 percent to 5 percent of the loan amount, as well as costs paid overtime. Many of these costs are the same as primary mortgages but are assessed and paid separately, as these are separate loans. Quite often, they’re even issued by different lenders. Some of the costs of second mortgages include origination fees (often 1 percent to 2 percent of the loan amount); interest (with rates typically starting at prime, plus 2 percent); title work, and documentation preparation fees (usually a few hundred dollars to $1,000); and an appraisal fee (if you need a new appraisal, you’ll probably pay a couple hundred dollars for one).
Reasons to get a second mortgage
Some of the reasons people get second mortgages are to add on to their house or make other improvements, to access the equity in their home to start or buy a business (second mortgages can be less expensive than business loans), and to take a nice vacation or finance a large purchase. Among the most common reasons: to make improvements to the property; invest in a business; pay off higher-interest debt; and finance a vacation, wedding, or other large purchase
What are the pros and cons of a second mortgage?
PROS:
• Don’t have to refinance your first mortgage
• Don’t always have to get a new appraisal
• May be able to draw money over time and only pay interest on what you borrow
• Good way to build your credit if you pay on time
• Loans often are less expensive than other types of debt
• Some loans are interest-only, which makes them less expensive
CONS:
• Have to pay origination fees on new loan
• May need to pay for a new appraisal
• Reduces the equity in your home
• Debt may have to be paid off in a lump sum if lender doesn’t renew your loan
• Increases your monthly debt load
Steps to get a second mortgage
The key difference with second mortgages is that you already own the property. Borrowers who want a HELOC or home equity loan should follow five basic steps:
1. Choose a lender. If you already have an existing relationship with a bank, that’s usually the first place to look.
2. Apply for a loan. Each lender has its own application process, with different documentation requirements.
3. Provide personal financial information. Your lender will want to see a good deal of information about your financing, including pay stubs and usually two years of tax returns.
4. Submit to appraisal and inspections as necessary. If your property hasn’t been appraised in the past three to six months, your lender likely will want to get a new appraisal and may even want to inspect the property.
5. Close and secure loan proceeds. Once your loan is approved, you can close on the loan and get access to your funds.
