What Is A Second Mortgage? Rates, Uses and More

A second mortgage is a home loan that allows you to borrow home equity while you already have a current or “first” mortgage on the property. Second mortgage rates are usually slightly higher than first mortgage rates, but these loans can still make sense for homeowners who want to pay off debt, make home improvements or avoid mortgage insurance.

What is a second mortgage?

A second mortgage is another loan taken out against your home equity while you still have a mortgage on your home. Your home equity is the difference between how much you owe and the value of your home. A second mortgage can be combined with a first mortgage to refinance or purchase a home.

The term “second mortgage” refers to how lenders are paid in foreclosure: A second mortgage loan is paid only after the first loan balance has been paid, which means that if there isn’t enough equity left, the lender may not get all of their money back. Because of that added risk to the lender, second mortgage rates are usually higher than first mortgage rates.

Types of second mortgages

The most common types of second mortgages are home equity loans and home equity lines of credit (HELOCs). Both allow you to borrow against your home’s equity, but they work very differently.

Home equity loans

In most cases, a home equity loan is a fixed-rate second mortgage. You receive funds in a lump sum and pay the balance in even installments over terms ranging between five and 30 years. You’ll typically pay closing costs equal to 2% to 5% of your second loan amount and can use the cash to buy or refinance a home.

Rates are usually higher and the qualifying requirements are more stringent than a first mortgage. For example, the maximum loan-to-value (LTV) ratio for a first mortgage is usually around 97%, but for a second mortgage, many lenders won’t go above 85%. The funds from a second mortgage can be used to buy or refinance a home, or for anything else you can buy with cash.

Home equity lines of credit

Most home equity lines of credit are second mortgages, but they can also be secured by a home without a first mortgage. A HELOC works like a credit card for a set time called a “draw period,” during which you can use and pay off the balance as needed. During the draw period, some HELOCs allow you to only pay off the interest on any money you’ve borrowed. But once you enter the repayment period, you’ll have to begin repaying the loan balance. You’ll usually have 15-20 years to pay the loan off in full at a variable interest rate.

Unless you have a no-closing-cost HELOC, closing costs will likely run you 2% to 5% of the loan amount. You may also pay ongoing fees for account maintenance or a close-out fee when you pay off the HELOC. Some lenders also impose minimum withdrawal requirements and inactivity fees that penalize you if you don’t utilize the line of credit very much.

Second mortgage rates: What to expect

• You’ll typically pay a higher interest rate with a second mortgage. That’s because second mortgage lenders take on more risk that they won’t be paid if you default on the loan, since the first mortgage will be paid first if you go into foreclosure.
• You’ll have to choose between fixed or variable interest rates. Home equity loan rates are normally fixed, while HELOC rates are usually variable.
• Your LTV will affect your rate and your closing costs. In most cases, the higher your LTV ratio is, the higher your rate will be. If it’s a conventional second loan, you’ll also pay more in fees at closing the higher your LTV ratio climbs.
• Your credit score will partially determine your rate. Borrowers with credit scores of 740 or higher are often rewarded with the lowest second mortgage rates. For conventional loan borrowers, 780 will unlock the best rates
• You could pay an extra fee when refinancing. If you’re refinancing a conventional loan, having a second mortgage on your home will add a fee to your closing costs — but only if it will remain after the refinance closes. In a case like that, you can expect to pay between 0.625% and 1.875% of your total loan amount.

Uses for a second mortgage

Second mortgages offer homeowners a way to free up some of the hard-earned cash they’ve put into their homes. In general, a second mortgage can make sense if:

• You’re happy with your first mortgage rate but want to tap some home equity. With a second mortgage, you can convert equity to cash without touching your low-rate first mortgage. The funds can be used to pay off credit card debt, cover college tuition or as a financial cushion for unexpected future expenses.
• You want to avoid mortgage insurance on a home purchase. You can buy a home with a down payment as low as 10% with a “piggyback” second mortgage. A first mortgage is taken out for up to 80% of the home’s price, and the second mortgage “piggybacks” on the first, allowing you to avoid paying mortgage insurance.
• You want to borrow more equity than a cash-out refinance will allow. A cash-out refinance is when you take out a new first mortgage for more than you currently owe and pocket the difference. Most first mortgage cash-out refinance programs allow you to borrow up to 80% of your home’s value. Second mortgage loans are available for up to 100% of the value of your home, although most are capped at 85%.

However, home equity loans and HELOCs are structured slightly differently, which makes each one best for different situations. Here are some typical scenarios where you might want to utilize each loan type.

It may make sense to get a home equity loan if:

• You need extra cash to buy a home before your current home sells. It can be hard to time the sale of your current home with the purchase of a new home. If you need to buy a new home before completing the sale of your current home, you can take out a first mortgage and a second mortgage that covers the profit you’re expecting from your current home. When your old home sells, you can pay off the second mortgage with the sale proceeds.
• You have higher education costs that require a large lump sum of money. Higher education is only getting more expensive, which can put many families in a tough spot when their kids hit college age. A home equity loan can help you pay tuition, and the relatively long repayment period and fixed interest rates can make for less expensive loan payments that won’t change.
• You’re buying a rental property. If you need funds for a down payment on a rental property, a home equity loan might be just the ticket — and as soon as you get renters into the home and your investment starts yielding profits, you’ll have money coming in to help repay the loan.
• You’re making home improvements that have a defined scope and budget. If you want to remove any temptation to borrow more than you intended, a home equity loan is the better choice. Unlike with a HELOC, where you can use the line of credit as many times as you’d like during the draw period, a home equity loan is just a lump sum that you can access only one time.

It may make sense to get a HELOC if:

• You need to make some minor home improvements. If you don’t have the cash on hand to upgrade kitchen appliances or replace old flooring, for example, a HELOC can help. Especially if you’re going DIY, we all know that the improvements will likely unfold without a set-in-stone timeline or budget. That’s why a HELOC may make more sense, as it allows you to access funds as needed.
• You need help covering ongoing medical debt and expenses. Either type of second mortgage can be a good way to consolidate debt, but if you have a medical situation that’s likely to continue to require costs along the way, a HELOC may make more sense than a home equity loan.
• You’re living on a fixed income. If you’re retired and living on a fixed income, it can be tough to roll with the punches when financial speedbumps come up. Whether it’s downturns in the market, a hole in the roof or a temporary loss of rental income a HELOC can help you cover expenses. And you don’t have to know how much you’ll need ahead of time, since you can use the line of credit just like a credit card.

How does a second mortgage work?

The second mortgage process is similar to getting a first mortgage. You fill out an application and the lender reviews your income and credit history and verifies the value of your home with some type of home appraisal. However, there are a few notable differences when it comes to second mortgage requirements:

→ You can’t exceed the lender’s combined loan-to-value (CLTV) ratio limits. Your LTV limit is calculated by dividing how much you’re borrowing by your home’s value. With a second mortgage, the lender adds the balance of both your first and second mortgage to determine your CLTV. Most lenders cap the CLTV at 85%, although some may lend you up to 100% of your home’s value.

→ You’ll need a higher credit score than first mortgage programs. A 620 credit score is the minimum for many second mortgage lenders, while others set the bar as high as 680.

→ You must qualify with two mortgage payments. A second mortgage means you’ll make two house payments. Second mortgage lenders usually require a debt-to-income (DTI) ratio of no more than 43%, although some lenders may stretch the maximum to 50%. Your DTI ratio is calculated by dividing your total monthly debt, including both mortgage payments by your gross income.

→ Your first mortgage will affect the second mortgage loan amount. You’ll be limited to borrowing the difference between what you own on your current mortgage and the maximum LTV of the second mortgage program you apply for. Here’s an example of how the numbers could look.

If you have a rough idea of your home’s value and your current loan balance, try our home equity loan calculator to estimate how much second mortgage money you may be eligible for.

Pros and cons of a second mortgage

Pros

  You can access your home equity without refinancing your first mortgage.

  You may be able to deduct second mortgage interest from your taxes if the funds are used for home improvement or to buy the home.

  You can buy a home with less than 20% and avoid paying mortgage insurance.

  You can consolidate debt at a lower interest rate than you’d pay with a personal loan or credit cards.

  If you use the money on home improvements, to start a business or for investing, you can use the money to create equity or future income.

Cons

  You could lose your home if you can’t make your payments and the lender forecloses.

  You’ll pay a higher interest rate than a first mortgage.

  You’ll need a higher credit score and lower DTI ratio to qualify.

  You will net less profit when you sell your home.

  You can lose access to your HELOC funds if your lender decides to freeze your line of credit due to changes in your financial situation.

  You may find it more difficult to refinance, since both the original lender and your second mortgage lender will have to agree to the refinance.

  You’ll have to cover the costs and fees that come along with a second mortgage like appraisal fees, origination fees and closing costs.

Alternatives to a second mortgage

Cash-out refinance

A cash-out refinance is another common way of converting home equity into cash. Unlike a second mortgage, though, it doesn’t sit in the second position behind your existing home loan. Instead, it replaces your home loan with a loan for more than your home is worth. You then pocket the difference as a lump sum payout.

Personal loan

If you’re debating getting a personal loan versus a home equity loan, one key difference to focus on is that personal loans allow you to avoid putting your home at risk. Unlike home equity loans, personal loans are unsecured debt — if the worst happens and you go into default on the loan, your home is safe. For many borrowers, that peace of mind is worth more than the lower interest rates that come with second mortgages.

Debt consolidation loan

Debt consolidation is a strategy for paying off debt where you use a new loan to pay off multiple other loans with outstanding balances. In general, you’re aiming to use a personal loan or balance transfer credit card with a lower interest rate to pay off debts that carry higher interest rates.

Reverse mortgage

A reverse mortgage is another way to tap your home equity, but it’s only available to borrowers who are 62 and older and have at least 50% equity in their homes. It’s unique in that it requires no monthly payments. Instead, the lender pays out cash to you from your home equity each month. The loan only needs to be repaid if you move, die or fail to maintain the home.

Home improvement loan

If you need a way to fund home renovations or improvements, there are several conventional and government-backed options tailored to your situation. A Fannie Mae HomeStyle renovation loan allows you to fund renovations with as little as 3% down and allows DIY work. FHA 203(k) loans are a similar option, but have more restrictions on what type of work you can do and how long it can take.