Understanding the basics of a second mortgage

Home appreciation values are up 56% over the past five years. By the end of this year, home value appreciation is expected to grow another 5.5%. This provides homeowners with the ability to tap into more home equity as it grows. 

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One way homeowners can tap into home equity as a source of funding is by taking out a second mortgage. Homeowners often take out second mortgage loans to renovate their homes, pay down debt, or finance a child’s college education. 

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In this blog, we’ll discuss how to get a second mortgage, what factors determine approval, the pros and cons of taking one out, and how second mortgages compare to other financing alternatives.

Understanding second mortgages

A second mortgage is a loan taken out in addition to a regular mortgage loan, resulting in two monthly mortgage payments for the borrower. They can be taken out with the same lender as your first mortgage or a different lender. When you take out a second mortgage, a lien is placed on your property by the lender until it is repaid. They usually come with higher interest rates than first mortgages. However, the rates are usually lower than those for unsecured loans, such as personal loans. 

How does a second mortgage work?

Applying for a second mortgage is very similar to applying for a first mortgage. Lenders usually require an income verification, credit check, and home appraisal to determine whether or not a borrower qualifies for a second mortgage. 

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Homeowners can usually borrow up to 85% of their home’s current value, minus their first mortgage balance. For example, if your home is worth $500,000 and you still owe $300,000, you could potentially borrow up to $125,000 through a second mortgage ($500,000 x 0.85 - $300,000).

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Additionally, lenders will want to confirm that you can handle two mortgage payments and have a history of paying your debts on time. Each lender will have its own income requirements. However, most lenders want to see a credit score of 620 or better. The higher your credit score, the better your interest rate and repayment terms will be. 

How to get approved for a second mortgage

Whether or not you get approved for a second mortgage depends on three  key factors: the amount of equity in your home, your credit score, your debt-to-income ratio. 

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The amount of equity in your home is arguably the most important factor to consider when applying for a second mortgage. Lenders normally want borrowers to maintain 15-20% equity in their homes after taking out a second mortgage. 

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You can calculate your home equity by subtracting your principal payments from the total amount borrowed on your mortgage. Mortgage interest doesn’t affect home equity. However, market trends and home improvements can have either a positive or negative effect on a home’s equity. To get the most accurate home equity estimate, you’ll need an appraiser. 

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In addition to 15-20% of home equity, lenders also require the following:

• Credit score above 620 
• A debt-to-income ratio of 43% (although some lenders accept 50%)
• A steady and reliable source of income

Pros and cons of a second mortgage

Second mortgages come with several advantages for homeowners who need access to a large sum of funds. However, they also come with significant disadvantages borrowers should be aware of. Here’s a closer look at the pros and cons of taking out a second mortgage:

Pros 

• The interest on your second mortgage may be tax-deductible if the funds are used to renovate your home. 
• Second mortgages come with lower interest rates than unsecured loans. 
• There are no limits as to what you can use the funds for.
• There are flexible options for withdrawing funds, such as receiving a lump sum or through a line of credit. 
• Second mortgages often come with high loan amounts, with some lenders allowing borrowers to take up to 90% of their home’s equity.

Cons

• The lender could foreclose your home if you fail to make payments on either mortgage.
• Second mortgages come with higher interest rates and more strict requirements (higher credit scores and lower DTIs) than first mortgages, making it more difficult for some borrowers to get approved. 
• It may be more difficult to refinance if you have two different lenders since they’ll have to agree to refinancing terms.
• Second mortgages come with appraisal fees, origination fees, and closing costs, just like first mortgages. 
• You may not qualify if you haven’t accumulated enough home equity. 

Are second mortgages and home equity loans the same thing?

Home equity loans and second mortgages are often used interchangeably.  However, a second mortgage encompasses any mortgage loan subordinate to a first mortgage — such as cash-out refinances and equity-sharing agreements. 

Second mortgage vs. refinancing

The main difference between a cash-out refinance and a second mortgage is that a cash-out refinance replaces your current mortgage. As a result, it dislodges and replaces your existing mortgage rate and terms. In contrast, a second mortgage is an independent loan taken out in addition to your first mortgage, leaving your rate and terms intact. 

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Cash-out refinances usually come with higher closing costs, while second mortgages tend to have higher interest rates. However, both products give you access to funds. 

Second mortgage vs. equity sharing agreement 

A home equity sharing agreement (HEA) allows you to sell home equity for cash upfront and share future changes in equity with a purchasing entity. It works similarly to selling stock, except, instead of selling stock in a company, you’re selling stock in your home. 

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HEAs allow borrowers to receive a lump sum of cash without having to make monthly repayments or accumulate interest. Settlement occurs when the home is sold or the agreement ends. Although relatively new, HEAs are growing in popularity because they allow homeowners to tap into home equity without having to commit to monthly repayments or interest.

Second mortgage vs. home equity line of credit

Is a HELOC a second mortgage? Unlike most products, a HELOC offers a line of credit compared to a lump sum amount. However, a lender still places a lien on the property.

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Homeowners can access funds whenever needed over a set draw period, usually five to ten years. Once the draw period ends, the repayment period begins, and the balance is converted into a principal-plus-interest loan. HELOCs have variable interest rates that are impacted by market fluctuations. 

Tips for managing a home equity loan, equity line of credit, or second mortgage

Managing a second mortgage requires borrowers to be strategic and organized with their finances. Before committing to a second mortgage or any kind of home equity loan, carefully assess your personal finances by considering monthly income, existing debts, and living expenses.

Budget appropriately 

The first thing you want to do when planning for a second mortgage or a home equity line of credit is to create a comprehensive budget accounting for all homeownership costs, including mortgage payments, utilities, insurance, and property taxes. As a homeowner with two mortgages, you should maintain an emergency fund to cover unexpected expenses and plan for future financial needs such as college education, vacations, and weddings. Make sure to factor these major life expenses into your budget.

Use the funds responsibly

If you have substantial equity in your home, it can be tempting to take out more than you need. However, it's best to have a specific goal in mind when taking out a second mortgage and avoid using the funds for anything else. A few good reasons to take out a second mortgage are for value-adding home renovations, high-interest credit card debt consolidation, and long-term investments, such as funding a business venture, college education, or investment property.

Consider the potential impact on your credit score 

Lastly, it’s important to consider how second mortgages and home equity lines will affect your creditworthiness in the future. Making on-time payments on your second mortgage is just as important as making on-time payments on your first mortgage. Defaulting on either payment could lead to a negative mark on your credit score, making it difficult to borrow money in the future. In severe cases, defaulting on the loan can cause you to lose your home. 

Final thoughts on second mortgages

A second mortgage can be an extremely useful tool for accessing home equity when you need it most. They come with several advantages such as lower interest rates, flexible withdrawal options, and potential tax deductions. However, they also come with a fair amount of risk, particularly foreclosure. Second mortgages also come with origination fees and closing costs, adding to financing costs.

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Deciding whether or not a second mortgage is a good idea depends on your financial situation. Home equity, credit score, and outstanding debt at the time of applying are particularly important. It’s also important to keep in mind that second mortgages come with stricter application requirements than first mortgages. If you fall short of a mortgage lender's required DTI ratio or credit score, you may need to put down a down payment of 20%, or more. 

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Being able to access home equity is important for any homeowner, however, it can be difficult for a borrower who doesn’t meet a lender’s qualifications. A Home Equity Investment (HEI) may be a sound financing alternative for homeowners who are struggling to take out a second mortgage. An HEI provides homeowners with a lump sum of funds in exchange for a share of future appreciation in their home. There are no monthly payments; you can buy back your equity anytime during a 30-year term. Visit Point to find out if you qualify for an HEI so you can tap into your home equity with ease.