Second Mortgage: What You Need to Know
Owning a home may be a dream come true for some, but it can also be an expensive endeavor. Not only do homeowners have to keep up with their monthly mortgage payments, but they have to pay for adequate insurance coverage, property taxes and sometimes private mortgage insurance (PMI). Add in the cost of upkeep, repairs and major component replacements, and it’s easy to see how owning a home can be costly in the long term.
Fortunately, it may be possible to borrow against the equity you have in your home — even if you already have a mortgage. This option is available thanks to the wide range of second-mortgage loans on the market, some of which come with low fees and lower interest rates than if you borrowed money via a personal loan or credit card. If you’re considering a second mortgage but want to know all your options, here’s the info you should have.
What is a second mortgage?
A second mortgage is a loan you take out using your home as collateral while maintaining the original loan on your home. While some second mortgages work as a line of credit you can borrow against when needed, others offer a lump sum of cash.
One important detail to note with a second mortgage is that it will be paid off second in the event you can no longer afford your mortgage payment and your home is sold off to repay your debts. The Consumer Financial Protection Bureau (CFPB) also notes that a second mortgage may never be repaid in full if the sale of your home doesn’t produce enough profit to cover both loans. Because of that, the interest rate on a second mortgage may be slightly higher than the rate on a first mortgage.
Kinds of second mortgages
- Lump sum: One type of second mortgage, known as a home equity loan, releases your funds in a lump sum. When you apply for this type of second mortgage, you will receive your loan funds in their entirety along with a fixed repayment schedule and fixed monthly payment.
- Line of credit: You can also secure a second mortgage that works as a line of credit. This type of second mortgage is known as a home equity line of credit, or HELOC. With a HELOC, you receive a line of credit you can draw from as needed. HELOCs typically have a draw period, during which you can borrow money, and a repayment period, during which you repay your loan without the ability to borrow more.
- Rate options: Make sure you research rate options before you choose among second-mortgage products. Where home equity loans typically come with a fixed interest rate that won’t change, HELOCs come with variable rates that can change from month to month. The variable rate on a HELOC is typically based on an index, such as the prime rate published in the Wall Street Journal.
- Term options: Also be aware that terms can vary among second mortgages. Home equity loan terms can range from five to 30 years depending on your needs. HELOCs can also vary in length, but many include a 10-year draw period followed by a 20-year repayment period.
Advantages of second mortgages
Before you consider other borrowing options, it’s important to understand the benefits that may come with borrowing against the equity in your home. Here are some of the main advantages you can get with a home equity loan or HELOC.
You may qualify for a lower interest rate than you would with other borrowing options.
Because second mortgages use your home as collateral, interest rates offered are typically lower than rates on unsecured personal loans and credit cards. Keep in mind that the average credit card interest rate is more than 15%.
Lock in a fixed interest rate.
While HELOCs tend to come with a variable interest rate based on an index, home equity loans usually come with a fixed APR. Rates on HELOCs may also be very competitive, but home equity loans can be a valuable tool if you want to lock in a low fixed interest rate to avoid future rate hikes.
Access your home equity and maintain your cash reserves.
Borrowing against the equity in your home can help you access cash you couldn’t otherwise. By accessing this trapped wealth, you can maintain your cash reserves and financial integrity while still getting the money you need.
Use the money however you want.
Second mortgages allow you to borrow against the equity in your home, but you are not required to use your funds for housing-related expenses. You can use the money in any way you see fit, whether that means splurging for the trip of a lifetime, consolidating debt or remodeling your kitchen.
It’s possible you could deduct the interest on your taxes.
The Tax Cuts and Jobs Act of 2017 initially created some confusion over whether consumers could continue to deduct interest from home equity products on their taxes. However, the IRS has confirmed that consumers can continue deducting this interest on their taxes if the funds are “used to buy, build or substantially improve the taxpayer’s home that secures the loan.”
In other words, you can deduct the interest from these products on your taxes if you use the money to remodel your home, add a room addition or improve your home in any substantial way. You cannot deduct that interest if you use the loan to consolidate debt.
Disadvantages of second mortgages
Borrowing against the equity in your home does come with advantages, but that doesn’t mean there aren’t any risks.
You could lose your home.
One of the biggest downsides that comes with taking out a second mortgage is the fact that you could lose your home if you’re unable to repay. Because second mortgages use your home as collateral, you’re putting your house on the line.
You’re racking up more debt.
The CFPB warns that any time you take out a second mortgage, you add to your overall debt burden and make yourself more vulnerable if you hit tough times. Keep in mind that you’ll have to repay all the money you borrow, plus interest and fees. The more money you borrow, the harder it may be to repay if you experience financial hardship.
Interest rates can climb.
The type of second mortgage you choose will determine whether you have to worry about rising interest rates. While home equity loans tend to come with fixed rates, remember that HELOCs usually come with a variable rate. If interest rates rise considerably, the monthly payment and total borrowing costs for your HELOC will go up, too.
There are costs associated with taking out a second mortgage.
Home equity loans and HELOCs usually come with closing costs and fees (including an origination fee), although you may be able to wrap these costs into your loan amount.
However, you can minimize these costs by shopping around for second mortgages to find the best deal. Some home equity loans come with no annual fees, no closing costs and no application fees, so make sure to check around and compare. Keep in mind that going with a no-closing-cost second mortgage could mean a higher interest rate, or these costs could just be added to your total mortgage balance, so it may not pay off in the long run.
Six common uses for second mortgages
A second mortgage can come in handy if you need money for almost any reason. Here are some of the most common uses.
- Home improvement: While you can use a second mortgage to pay for important upgrades or component replacements, such as a new HVAC system or roof, you can also improve the utility or beauty of your home. Many homeowners rely on the funds from a home equity loan or HELOC to remodel their kitchen, expand the size of their home, replace flooring or upgrade a bathroom.
- Debt consolidation: Second mortgages can be a valuable tool for debt consolidation if you’re able to qualify for a low interest rate. By transferring high- interest credit card debt to a low-interest second mortgage, you have the potential to save money on interest and pay down debt faster.
- Down payment for a second home: If you have considerable equity in your primary residence but want to purchase a second home, you can use a second mortgage to access money for a down payment.
- Higher education: You could use your home equity loan to fund higher education for yourself or a dependent, but you should only do so if the financials make sense. The interest rates on most federal student loans vary between 5.05% and 7.6%, so make sure to compare rates and all your options before you decide.
- Borrow money for a wedding: If you own a home and need to pay for a wedding, borrowing with a second mortgage may help you secure a lower interest rate than you could get with a credit card or personal loan.
- Start a business: If you need capital to start a business, borrowing against your home equity can be a smart move. You can access the money you need and potentially qualify for a lower interest rate than you could get with other types of loans.
Borrowing against your home equity can help you accomplish many personal and financial goals, but that doesn’t mean it’s a good option for everyone. Make sure to consider the pros and cons of borrowing money with any method — especially when you’re putting your home at risk.
Also make sure you don’t go with the first lender you come across — at least without conducting due diligence first. The HELOC and home equity loan business is rather competitive, so make sure to shop around and compare all rates and terms before you pull the trigger. To start, you can check out LendingTree’s home equity loan calculator.