A second mortgage enables you to borrow against the equity of your home. Owning a home is an asset, and over time your home will grow in its financial worth. A second mortgage is also called a home equity line of credit (HELOC) and is a loan that allows you to use the value of your home to invest in a particular venture.
What is a Second Mortgage?
A second mortgage is a loan which uses the value of your home as collateral. This loan is referred to as a second mortgage because the purchase loan is the first mortgage secured by a lien on your property. Second mortgages use the equity in your home, which is the market value of a property less any loan balances. The capital can increase and decrease but traditionally grows over time. There are three ways equity can change.
- Monthly payments on your loan reduce your overall balance and strengthen your investment.
- Your home may gain value in a robust real estate market or improvements on your home may also increase its worth, increasing equity.
- Your home can lose value, or you can borrow against your home which reduces its worth.
There are also many different types of second mortgages.
- Lump Sum: The most common form of a second mortgage provides a lump sum to borrow and use for whatever you choose. This loan is paid off gradually over time with fixed monthly payments. Each payment pays a part of the interest accrued as well as a part of the principal loan balance. This payment process is called amortization.
- Line of Credit: A line of credit loan does not require you to take out a specific amount of money but allows you to access a maximum borrowing limit set by your lender and the value of your home. This loan is similar to a credit card where you can borrow and make repayments multiple times over.
- Rate Choices: Different rates may be available depending on the type of loan you choose and what is offered by your lender. A fixed interest rate will not change for the life of the loan while a variable interest rate can increase or decrease according to market value. Variable interest rates are common with unsecured credit lines.
Second Mortgage Advantages
- Loan Amount: Second mortgages enable you to borrow considerable amounts of money secured by your home’s equity. These loans allow you access to more capital than would be available using your home as collateral. Your lender may let you borrow up to 80% of your home’s value. The maximum loan amount considers all of your home loans, including your first and second mortgages.
- Interest Rates: Second mortgages typically have much lower interest rates than other loans. Securing the loan with your property reduces the risk for the lender, and allows interest rates enter single digits. Unsecured personal loans, such as credit cards, have much higher interest rates.
- Tax Benefits (pre-2018): You may be able to get a deduction for the interest paid on a second mortgage. Discuss with your tax preparer what options are available to learn more about mortgage interest deduction. After 2017, the Tax Cuts and Jobs Act eliminates this deduction unless the borrowed money is used towards “substantial improvements” to your home.
Disadvantages of Second Mortgages
There are many costs and risks associated with borrowing against your home's equity. Borrowers should carefully consider these factors when considering a second mortgage.
- Risk of Foreclosure: The highest risk of taking out a second mortgage is losing your home. If you fail to make necessary payments, the lender can take your home through foreclosure. For everyday living expenses, a second mortgage is much too dangerous. The money borrowed in a second mortgage should go towards a specific investment project that you can pay off promptly.
- Cost: Second mortgages, similar to the original purchase loan, come with expenses and fees associated with the legal process. Closing costs such as credit checks, appraisals, and origination fees may add to the total amount due at the start of the loan or can add to the total amount borrowed.
- Interest Costs: While second mortgage rates are typically lower than unsecured lines of credit, they may be slightly higher than your first mortgage. Any time you borrow money, you are paying interest. The second mortgage lender is taking a higher risk than the lender of your original purchase loan.
- Beware: If you stop making payments on your second mortgage, the second lender will not get paid until the initial loan is completely satisfied. The total interest accrued on the second mortgage can add up over time with such a large amount of money borrowed.
Common Uses of Second Mortgages
- Since taking out a second mortgage can be risky, it is essential to use the money wisely, preferably to increase your net worth or the value of the home.
- Home improvements are typically used for second mortgages because many assume they will be able to pay off the loan with the increased sale value of their home.
- Avoiding private mortgage insurance (PMI) is another use for a second mortgage to keep the loan-to-value ratio of the first loan above 80%. A piggyback loan strategy combines loans to eliminate the need for PMI. Private mortgage insurance is obligatory for borrowers who hold less than 20% of the equity in the home.
- Debt consolidation allows you to use lower interest rates than what would be available with an unsecured personal loan. The benefit of a low-interest rate second mortgage may cost you your home.
- Education is an investment that may provide you with a higher income in the future. However, an increase in salary is not guaranteed, and you may be faced with foreclosure if your income does not support the additional mortgage payments. Standard student loans may be a better option for financing education.
Tips for Getting a Second Mortgage
For the best mortgage rates, it is essential to shop around and talk to at least three different lenders.
- A local bank or credit union
- A mortgage broker or loan originator
- An online lender
Prepare to interview various lenders by compiling the required documents and moving your money in the right places. Financial planning will make the process much more seamless and less confusing. Beware of Risky loan features can cause problems down the line. Ballon payments and prepayment penalties are hidden costs that may increase the amount of money you planned to borrow or impact your ability to pay off the loan.