What is a Second Mortgage?

Building equity is a huge benefit of homeownership. Your home equity can become a huge cash resource that you may not otherwise have at your disposal. But how do you go about turning it into usable funds?

A common way homeowners tap into equity is by applying for a second mortgage. However, it is important to understand what they are and how it works. That way, you can choose the right financial option for your unique situation.

What is a second mortgage?

A second mortgage is a home loan that is taken out against a house without making any changes to its first mortgage. You may also hear them referred to as junior liens. Second mortgages allow borrowers the opportunity to withdraw a certain amount of money that correlates to how much equity you have built.

Home equity is based on the amount you have already paid off on your first mortgage, how much is left to pay off, and the home’s appraised value. Once you have access to these equity funds, you can use them for whatever you want, including:

• Home improvement expenses

• Debt consolidation

• Financing education tuition

• Investment property

Home equity loan versus HELOC

When it comes to deciding what type of second mortgage is right for you, it is vital to understand the differences between your options—home equity loans and home equity lines of credit (HELOC):

Home equity loan: A fixed amount of money that you receive in a single lump sum at closing. This type of loan typically comes with a fixed-interest rate. A home equity loan is most useful for borrowers who are looking to tackle a big project with a specific price or budget in mind. Since all of your funding is provided at once, you will know exactly what your monthly payments will be from the beginning.

However, you will have to pay for interest on the full loan amount, regardless of whether or not you ended up needing all of the funds.

HELOC: A revolving line of credit based on the equity you have in your home. Your lender sets a limit, and you can withdraw the funds as you need them during the initial draw period (typically 10 years). When the repayment period begins, you cannot access the remaining balance on the line of credit, and you are only expected to pay interest on the amount you used.

With a HELOC, the rate will be variable. On average, though, initial rates for HELOCs are typically lower compared to other loan options.

It is important to note that not all lenders offer both HELOCs and home equity loans so be sure to discuss the available financing options with your preferred lender. 

Is a second mortgage the same as a refinance?

No, second mortgages and refinances are not the same. When you take out a second mortgage, your first mortgage and its monthly payments remain intact. The purpose of refinancing is to replace or update your current mortgage with a new one. There are refinancing options that allow you to receive cash-back, but you can also choose to switch your current mortgage to one with a lower rate and a different term.

Another option for tapping into your equity is a cash-out refinance. This type of refinance replaces your existing mortgage with a new home loan that comes with a different rate and term, plus a lump sum of funds at closing.

Can you consolidate a first and second mortgage?

You may be wondering if it is possible to consolidate your first and second mortgage into one loan. Yes, you can! As long as it financially benefits you and you meet the eligibility requirements, it is possible refinance both mortgages into a single loan.

Qualifying for a second mortgage

Different lenders will have their own borrower requirements for each type of second mortgage, so it is important to shop around for one before you begin submitting applications. In general, though, if you can meet the following prerequisites, then you are likely to qualify:

• Credit score is 620 or higher

• At least 15% to 20% home equity

• Debt-to-income (DTI) ratio is 43% or lower

• Remaining mortgage balance is less than 80% of the home’s appraised value

Most lenders will also require a home appraisal before they can approve your application. This is to ensure they are not lending you more than what the home is actually worth.

Is a second mortgage the right option for you?

A second mortgage can be a great way to tap into your equity and turn it into cash. However, it is important to have a plan for your funds so you do not end up spending it on just anything. Investing in home improvements that increase value is a good way to put your new funds to use. That way you will be well on your way to rebuilding your equity or getting more money if you decide to sell. You could also use your second mortgage to pay off other debts or invest in higher education expenses.

The first step to making the best financial decision for your unique situation is understanding all of your options. Reaching out to your lender to discuss all of the possibilities is a great place to start.