Second Mortgage: What Is It, And How Does It Work?

Once you’ve finally purchased your desired home with your first mortgage, you may need a second mortgage for another project. There are many reasons why someone needs access to a large sum of money. You may think of opening a new business, or you may need to consolidate a few high credit card balances. Or you may want to increase your newly purchased home value by improving it.

Regardless of your reasons, you may need to consider tapping into your home’s equity, also known as taking a second mortgage. Simply put, a second mortgage is a loan that uses the equity in your home as collateral. This type of loan is called a second mortgage because they follow your first mortgage or the mortgage you use to purchase your home.

This article explains everything you need to know about a second mortgage. This may include different information such as its definition, the methods to get it, and the pros and cons of getting a second mortgage. So, without further ado, here is everything you need to know about a 2nd mortgage.

What Is a Second Mortgage?

When taking a second mortgage, you are essentially borrowing some money from the equity you’ve built up in your home. In other words, your home equity is equal to the difference between your current home value and the remaining balance on the first mortgage. In most cases, homeowners gain access to equity by taking a home security loan, also known as a home equity line of credit (HELOC.)

As stated by Bankrate on February 02, 2022, a second mortgage uses an existing mortgaged property to borrow funds from a certain financial institution. As previously mentioned, a second mortgage acts as a follow-up to your first mortgage. However, unlike other types of loans, such as student loans or auto loans, you can use the funds from a second mortgage loan for many things.

The most common use of a 2nd mortgage loan is to consolidate other debts, especially the ones involving high-interest credit cards. In addition, second mortgages are also commonly used to finance home improvements or repairs. The low second mortgage interest rates, which are often much lower than a credit card,  are the primary reason for the wide variety of applications.

How Does a Second Mortgage Work?

What happens when you’re taking out a second mortgage? When homebuyers purchase a home, they typically use a home loan from a lending institution that uses the property as collateral. This loan is called the first mortgage, which must be repaid in monthly installments with the addition of the principal amount and interest payments.

After a certain period, as the homeowners paid their monthly payments, the purchased home value also appreciates economically. The difference between the home’s current value and the remaining mortgage is called home equity. The loan that homeowners take out against their home equity is a 2nd mortgage, which follows the first mortgage.

Like the first mortgage, homeowners must repay the second mortgage over a specified term and interest rate, which differs depending on the lean agreement with the second mortgage lenders. Furthermore, the second mortgage must be paid off first before homeowners can take out another mortgage against their home equity. In addition, you must have an excellent credit score to secure another mortgage against your home equity.

Different Types Of Second Mortgages

As of today, there are two common types of second mortgages you can find, namely home equity loan and home equity line of credit (HELOC.) Below are the full breakdowns of each type of the second mortgage:

  1. Home Equity Loan

Home equity loans are typically issued as a one-time lump sum, which means that you’ll receive all the funds at once instead of via payments made over time. In a home equity loan, you secure the loan against the equity in your home. In addition, you’ll need to repay the loan at a fixed interest rate, which means that you’ll pay the same amount of money each month. The second mortgage rate you receive will depend on your credit score.

In this type of second mortgage loan, the payment terms typically range between five to 30 years. If you fail to repay the loan according to the agreement with the lender, they can foreclose your home as a way to recoup the lender’s losses. Therefore, this type of second mortgage is more suitable for individuals with stable incomes.

One of the benefits of home equity loans comes from the fixed interest rate. This gives you monthly stability knowing what your monthly payment will be. In addition, the long repayment term increases the affordability of this loan. Despite the advantages, a home equity loan also possesses some disadvantages. For instance, it uses your home as collateral, which can be risky if you’re unable to repay the loan entirely.

  1. Home Equity Line of Credit (HELOC)

HELOC allows you to borrow money, repay it and use the credit lain to borrow money again. Think of HELOC as a credit card that uses your home equity as the security. As with credit cards, HELOC interest rates are also varied. In this type of second mortgage loan, the amount of available credit will replenish as you repay the balance.

In most cases, a HELOC has up to 10 years of the draw period. During this period, you may only be required to pay the interest of the funds used. Once the draw period ends, there will be up to a 20-year repayment phase, in which you must pay the principal and interest. As with the other second mortgage loan, the lender will foreclose on your property if you fail to pay as promised.

Compared to a home equity loan, a HELOC is more advantageous, especially if only need to borrow a certain amount of money. This will make your monthly payments lower. However, unlike home equity loans, HELOCs’ interest rates can drastically increase during their repayment phase. This increases the unpredictability of the monthly payment. In addition, this type of second mortgage loan uses your home as collateral. Therefore, HELOC is more suitable for disciplined borrowers who won’t risk borrowing more funds than they can repay.

Things To Consider Before Taking Out a Second Mortgage

While may sound convenient, taking out a second mortgage can be risky if you don’t know what you’re doing. So, be sure to consider these things before securing another loan from your home equity.

  1. Credit score 

Like any other type of loan, your credit score determines how likely you’ll be able to take out a second mortgage. In most cases, borrowers will use the FICO (Fair Isaac Corporation) algorithm to calculate their credit score. This system allows you to calculate your credit score based on several variables, including your income, total debt, and available credit, to give a score of 300 to 850. Typically, 2nd mortgage lenders prefer homeowners with a credit score of at least 620.

  1. 2nd mortgage rates

As stated by Rocket Mortgage on August 19, 2022, the 2nd mortgage rates tend to be higher than the primary mortgage. This is because second mortgages are deemed riskier for lenders. In the case of default, the primary mortgage holder will be repaid before the second mortgage. Still, second mortgage rates can be more attractive in certain cases, like paying off credit card debt for example. This is because of the much lower interest rate than those on credit cards or unsecured personal loans.

  1. Sufficient equity

The amount of money you can borrow from a second mortgage depends on how much equity you have in your home. As stated in Bankrate’s Home Equity Loan Calculator, the simplest way to calculate your home’s equity is by dividing your current mortgage balance by your home’s market value. For instance, if your current mortgage balance is $300,000 and your home’s market value is $600,000, you’ll have 50% of the equity in the home.

How To Get a Second Mortgage

If you urgently need some funds to cover medical bills, do home improvements, or pay off education expenses, you may want to consider getting a 2nd mortgage loan. Despite the convenience that the second mortgage offers, not many people seem to know the requirements for it. So, this article section is dedicated to details on the requirement for taking out a second mortgage.

As previously mentioned, you’ll need to have a credit score of at least 620 to qualify for a second mortgage. In addition, you need to fulfill some financial requirements. For instance, you’ll generally need to have a debt-to-income ratio of 43% and you’ll need to have a decent amount of equity in your home.

As stated by Investopedia on July 31, 2021, because you are using the equity in your home for the second mortgage, you’ll need to have enough equity for the second loan and be able to keep around 20% of the home’s equity in the first mortgage.

Besides those financial requirements, there are other special considerations that you should know, namely:

  • Borrowing limits

Although varied between second mortgage lenders, you’ll typically be allowed to borrow at least up to 80% of your home value. However, some lenders allow you to borrow more. Regardless of the amount, you need to make sure that you can cover your first and second mortgage.

  • Approval time

The loan’s approval time varies between the types of mortgage and the lenders. As stated by the US Federal Trade Commission in December 2021, it typically takes the underwriter a few weeks to review your application, which could range between four weeks or longer.

  • Additional cost

Like your first mortgage, you’ll also need to pay some additional costs when taking out a second mortgage. These costs may include appraisal fees and origination fees. Furthermore, while most second mortgage lenders stated that they don’t charge closing costs, you’re most likely required to pay the closing cost as well.

Frequently Asked Questions

What are the cons of a second mortgage?

As stated by Credible on October 13, 2021, the cons of second mortgages include the risk of losing your home due to failure of paying the loans and the declining home value. As you know, second mortgage lenders use your home as collateral. In addition, there’s no guarantee that your home’s value will continuously appreciate.

What is the difference between a first mortgage and a second mortgage?

First mortgages are the primary lien on the property that secures your mortgage. It is the loan you use to purchase the home. On the other hand, second mortgages are funds borrowed against home equity. Simply put, it is your second loan after the first mortgage to fund other projects.

What happened to a second mortgage when I had already paid off the first?

In the case of subordination, your secondary loan will become your primary mortgage once the first loan has been paid off. However, keep in mind that you’ll need a subordination agreement with the lender, which can be very tricky.

How much equity can I borrow from my home?

The amount of equity you can borrow from your home depends on how much equity your home has. For instance, if your current home value is $200,000 and you owe $120,000 in the mortgage, you have $80,000 of equity. However, keep in mind that most lenders will limit the maximum amount of equity you can borrow, usually 80% to 85% of the available equity.

How many years is a second mortgage?

Your second mortgage term depends on what type of the second mortgage you choose. In most cases, second mortgage terms can range between one to 20 years. The shorter the terms, the more your monthly payment will be.

Final Words

Taking out a second mortgage is a smart financial solution when you’re in a pinch. Although you put your house at risk, you’ll receive loan interest that is lower than credit cards or personal loans. In addition, you can have up to 20 years to repay your debt, which is significantly longer than other types of loans.

Despite the advantages, it is essential to consider several things, including your credit score, your home equity, and your overall financial situation. So, be sure that you’re able to pay off the loan first before you consider taking out a second mortgage.

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