There may be no more of a controversial topic in the world of real estate than that of acquiring a second mortgage. And though the prospect of “taking out a second” can leave homeowners unsure of whether to take advantage of this bold financial move, a second mortgage can open up a myriad of investing and wealth-building opportunities (and in some cases be a far better use of your home equity).
The key is to make sure you know exactly what a second mortgage can do for you, and whether it’s a good fit for your current financial needs. So, here’s a simple, step-by-step guide to understanding the ins and outs of the second mortgage process.
(Note: This is Part II in our series on mortgages. Be sure to check out Part 1: Conventional Mortgage Lending.)
Your Second Mortgage Questions Answered
1. What’s a second mortgage, anyway?
A second mortgage is an additional home loan you take out using your house, instead of your earning potential, as collateral. As a result, second mortgages are often easier to acquire than a primary mortgage loan, as your property is providing the security for the loan — not your paycheck.
2. What types of second mortgages are available?
There are essentially three types of second mortgages:
- Home Equity Loans: In which you receive a lump sum you pay off via a fixed monthly payment over time (usually for a term of 15 or 30 years). Loans of this kind most often have a fixed interest rate and are in addition to your primary mortgage. Most of the time you will not pay closing costs for a home equity loan.
- Home Equity Line of Credit (Also known as HELOC): This type of loan acts like a low-interest credit card, in which you’re provided a pool of money you can draw from (usually over a term of five years, followed by a ten-year term of payback). Interest rates for this type of second mortgage loan are not fixed, and are usually situated somewhere near the prime rate (the prevailing interest rate at the time) plus whatever margin your lending institution adds.
- Cash Out Refinance Loans: A “cash out refi” is similar to a home equity loan, in that you receive a lump sum of cash. But with a cash out refinance, you “refi” for more than you owe, and take the difference in cash. For example, if you have a primary mortgage of $100,00 and you cash out refinance for $125,000, then you pocket the extra 25K, while increasing your overall mortgage amount to $125,000. A “cash out refi” becomes your “new” primary mortgage, as a result you will have to pay closing costs.
3. What are the advantages of a second mortgage?
You mean, besides being able to purchase that new Corvette you’ve been dreaming of?
Some of the big financial advantages of a second mortgage include:
- Low Interest Rates: Second mortgage interest rates are significantly lower than other forms of unsecured debt or private funding. Second mortgage rates are never as low as that of your primary mortgage loan.
- Equity Liquidation: Why wait 20 years to take advantage of the equity in your home? Taking out a second mortgage allows you to use some of that hard-earned liquidity that you have to build more financial stability.
- Tax Benefits: That same “write off the interest” principle that applies to your primary home loan also applies to that 30-year second mortgage of yours, meaning that second mortgage debt is always isn’t the scary monster some folks make it out to be.
4. What should I use my second mortgage for?
Some of the most common ways people use their second mortgage include:
- Home Improvement/Home Repair: Probably the most common use of a second mortgage, infrastructure investments in a home can pay big dividends when it comes to time to sell your property.
- Debt Consolidation: Though not an ideal choice, a home equity line of credit, or HELOC, can provide debt relief from mounting bills. Especially true considering the interest rate on a second mortgage is far preferable to many forms of unsecured debt (including that credit card debit your racked up in college).
- Education: Either in the form of college tuition or career re-training.
- Investment Opportunities: This is an often overlooked way to use a second mortgage, which is a shame considering that, if you know what you’re doing, an investment return can sometimes double or triple the interest rate of the home equity loan.
5. What should I NOT use my second mortgage for?
Well, the list is long, but would include things like:
- Eating expenses
- A baseball autographed by Reggie Jackson
Using the proceeds from a second mortgage on luxury items, or simply to stay on top of bills, is a recipe for second mortgage disaster, and can lead to dire financial consequences down the road.
6. How much can I borrow?
This will depend on the financial institution you borrow from. But a general rule of thumb is that you can borrow up to 60-85% of the equity in your home, minus the amount you still owe on the property. So, for example:
- If you own a home that is worth $500,000…
- …and your bank has agreed to lend you 85% of that amount ($425,000)
- ..and you still owe $300,000 on your home…
- You can borrow a maximum of $125,000!
7. Where should I look for a second mortgage?
The best place to begin your second mortgage quest is with the lending institution of your primary mortgage; they’ll often be able to offer competitive rates and terms, and it can make life easier to write one mortgage check a month. But it’s important you get as many quotes from second mortgage lenders as you can, in addition to your primary lender. This can include:
- Credit unions
- Other banks
- Mortgage companies
- Online lender
The key is to pit these lenders against each other so they compete for your business.
8. How do I avoid getting ripped off?
Though securing a second mortgage can be a sound financial decision, it also poses risk to your property; it is a process filled with more than a few “hidden costs,” if you’re not careful.
Your ultimate weapon in the second mortgage process is information. Before agreeing to embark on the second mortgage journey, here are a few crucial questions to ask before signing your name on the dotted line:
Is there voluntary insurance attached to this loan? Some lenders will ask to add this onto your loan. You don’t need it, and it’s quite costly.
Is there a balloon payment at the end of the loan’s term? Some loans come with a large payment baked in at the end. This can make for a lower monthly payment, but can be dangerous if you don’t budget properly for it.
Are there pre-payment penalties? Steer clear of lenders who penalize you for early payment. (There are plenty of other lender fish in the sea.)
What’s the total damage for all closing costs, credit checks, appraisals and origination fees? – Don’t let the “No closing costs” sales pitch fool ya. There’s always some form of “closing cost.” You want to make sure you budget for the cost of creating the loan accordingly.
What’s the margin add for a HELOC loan? Hopefully your lender won’t have any margin, meaning you’ll be borrowing money at prime, or close to prime. But this will depend on your credit history, and how many embarrassing high school pictures of the lender you can use as blackmail.
9. How do I know if a second mortgage is right for me?
Here are a few factors to consider whether you’re in a good place to add a second mortgage to your financial plan:
- Do you have a stable source of income? If you’re unable to keep up with monthly payments NOW, wait till you get more solid financial footing before plunging ahead with another loan.
- Can your budget handle the upfront costs? Though the fees associated with a second mortgage are less than with a primary mortgage, there are still fees. If the idea of a couple thousand dollars will send you into the “red,” it’s good to wait.
- Can you handle a rate increase? This is only relevant if you plan to take out a HELOC; most equity loans are at a fixed rate. But since HELOCs are tied to prime, it’s good to keep in mind that rates can (and very possibly) might go up.
- Do you have a good financial reason to borrow the money? I’ll let you decide what “good” means, but if you have a compelling motivation for a second mortgage (and the benefits outweigh the risks), you might be in a great position to take advantage of a second mortgage.
This isn’t to say second mortgages aren’t without risk: They can possibly put your home in jeopardy. But if you do your homework — and have a plan for how to leverage your existing equity into opportunity — you might find a second mortgage is the ultimate key to your financial freedom.