What is a second mortgage?

A second mortgage, also known as a home equity loan and home equity line of credit (HELOC), can help you if you're in a bind. But these loans also have their drawbacks.

Pat Howard 1600

Pat Howard

Published October 4, 2019

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KEY TAKEAWAYS

  • A second mortgage is a loan or line of credit using your house as collareral

  • The two main types of second mortgages are HELOCs and home equity loans

  • There may be closing costs associated with taking out a second mortgage that may make it unaffordable

  • Like a regular mortgage, if you don't pay off your second mortgage then you may lose your home

Most people are homeowners because they took out a mortgage on their home and agreed to pay it back over a number of years. As you make monthly mortgage payments, or if your home increases in value from when you took out the loan, your home’s equity may also increase.

Your home equity refers to how much of the home is actually yours, and is calculated by subtracting your remaining mortgage balance from the market value of your home. If you have positive equity, you can tap into that and take out a loan against the value of your house, also known as a second mortgage.

Second mortgages, also known as home equity loans and home equity lines of credit (HELOC), may be beneficial if you’re in a financial bind and use the loan to consolidate debt. The loans also may be beneficial if you plan on taking out a loan anyway, as they may provide significantly lower interest rates than unsecured debt like personal loans and credit cards.

However, second mortgages are risky, and using the money to further bad spending habits could send you into a potential debt spiral. Second mortgages, similar to your first mortgage, also require closing costs and fees that may cost you thousands of dollars. You’ll want to carefully consider if you need the loan and if it’s worth the added expenses.

Read on:

How does a second mortgage work?

A second mortgage is a loan you can take out against an already mortgaged property as a way to use your home equity to meet financial needs. How much you can take out for a second mortgage depends on how much home equity you have and your lender’s borrowing limits. Your income and your credit score are also considered.

Your lender caps how much you can borrow for a second mortgage by determining your home’s loan-to-value (LTV) ratio (limits how much of your home’s equity you can take out on a loan) and your debt-to-income ratio (measures your ability to repay the loan based on how much you make versus the debts you currently owe).

Most lenders stipulate that you can borrow up to 80% of your cumulative LTV if you have a favorable debt-to-income ratio (lower than 40%), meaning you’ll have at least 20% in equity unless your home depreciates in value or you stop making payments.

If you were looking to take out a second mortgage on your home that’s valued at, say, $350,000, the maximum lendable value of your house could potentially be $280,000 ($350,000 x 0.80 = $280,000). If you have a $150,000 remaining mortgage balance, you may be able to borrow $130,000 ($280,000 - $150,000 = $130,000) against your home.

With the Policygenius Mortgage Calculator, you can figure out whether a second mortgage makes sense for your financial situation.

Second mortgage types

There are two types of second mortgages: home equity loans and a home equity line of credit (HELOC). With a home equity loan, your lender is loaning you all the money at once. You then make monthly payments toward the loan over a set period of time. A HELOC, meanwhile, functions like a credit card and has a line of available credit, so you only spend the money when you need it.

Learn more about the difference between home equity loans and HELOCs.

Home equity loan

A home equity loan is a type of second mortgage that works similarly to a fixed-rate mortgage in that it’s a one-time, lump-sum loan usually at fixed interest rates. The balance is repaid over terms ranging from five to 30 years with flat monthly payments.

Home equity loans are best utilized when you’re making a large one-time payment, like home renovations, which may increase both the home’s market value and your equity.

Home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a type of second mortgage that functions like a credit card in that you only borrow what you need, when you need it. Just like your credit card, you have a spending limit, called your maximum line amount, that you can continue to access as long as your line of credit is open and you haven’t gone over the limit.

Your minimum monthly payments vary based on your balance utilization and are usually repaid with a variable interest rate.

The period of time that you can access HELOC funds is referred to as the draw period, which is generally open for 10 years. After the draw period expires, you’ll have a period of usually 20 years to repay the balance. A HELOC is ideal if you’re using it for periodic payments, like tuition costs.

How much does a second mortgage cost?

Like a mortgage, your second mortgage is divided up into two payment components that make up a single, monthly payment:

  • The principal, which is the amount you still owe
  • The interest, the amount you pay to the bank for lending you the money

But there are other payment considerations beyond just repaying the loan itself. Like your first mortgage, your second mortgage also requires you to pay certain closing costs and fees in order to close on the mortgage. If you only plan on taking out a modest amount, the added fees (which can run into the thousands) may not be worth the trouble on a small loan. Before taking out a second mortgage, be sure to check for the following fees, which include, but may not be limited to:

  • Credit check fees: Your lender will charge you a convenience fee for pulling your credit report.
  • Appraisal costs: Covers the cost of having an appraiser over to assess the value of your home.
  • Origination fees: The amount you pay your lender for processing your mortgage application, or loan origination. Typical fees included in your origination fee are application fees, underwriting fees, and processing fees.
  • Mortgage insurance: Required if your home equity slips below 20%.

Reasons you may take out a second mortgage

Before you take out a second mortgage, you may want to consider other options available to you, as taking out a second mortgage decreases your home equity and puts your home on the line, but here are some situations where taking out a second mortgage may make sense for you.

You want to increase your home’s market value

Because second mortgages use your home as collateral, that means you may have access to significant amounts of money. If your home is due for some pretty big renovations and home-improvement projects, a large, one-time expenditure using your second mortgage could be used to increase your home’s market value and increase your equity.

Lump-sum loans come with their drawbacks, however, as you may have overestimated how much you actually needed in renovations and use that money needlessly. Someone with bad spending habits could be tempted to spend a portion of the money on projects or luxuries they didn’t plan or budget for.

Read more about home improvement loans.

Access to more favorable rates

Interest rates for HELOCS and home equity loans are potentially lower than personal loans or credit cards. They’re also more accessible and easier to qualify for since the bank has the added security of using your home as collateral.

If you’re looking to consolidate high-interest credit card debt (variable rate is around 17%), you could use a home equity loan or HELOC (variable rate is between 5% and 6%) as a means of consolidation. But as we explain below, using your second mortgage as a means of debt consolidation may also be a very bad idea.

Reasons to not take out a second mortgage

For most people, a second mortgage may not make sense. Not only do you still owe a preceding form of debt (your initial mortgage), but you’re now responsible for repaying a second form of debt (your second mortgage), and both debts are secured by the home. That means if you fail to make payments, you may be bidding your house farewell.

You should also be cognizant that your home’s value could completely plummet, leaving you with a mortgage balance that exceeds your home’s current market value. Also known as going “underwater” on your home loan, if the home is sold while you’re underwater, you would still owe principal payments on the mortgage.

It also may not even be the best idea to use a second mortgage to consolidate debt. You may be getting a lower rate with your second mortgage, but your interest rate also hinges on your credit, so if your credit is already poor, you may not be getting that great of an interest rate anyway.

Lastly, if you plan on retiring and downsizing your home, your existing home becomes a crucial asset, and your home equity becomes a crucial source of income for the rest of your life. Tapping into a potential income stream for projects or luxuries could prove short-sighted in the long run.

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