August 20, 2021
7 MINUTE READ
Taking out a second mortgage is an excellent option for tapping into the equity you’ve built up in your home over the years. However, you will need to spend some time weighing out the pros and cons. After all, a second mortgage is a new debt against your home equity which will need to be paid down each month.
If you’re wondering, “How does a second mortgage work?” read on for what you need to know.
So, what is a 2nd mortgage?
The idea of a 2nd mortgage is that you’re taking out a secured loan against the home equity in your home. The more equity you have, the more you can borrow. However, drawing out a 2nd mortgage does mean that you will be required to pay off two mortgages every month.
Home equity is the value of your home less your remaining mortgage balance. Over time, the more principal you pay down, the more equity you accumulate. For example, if you buy a $300,000 house with $60,000, you automatically hold 20% equity in that piece of real estate. The starting mortgage balance will be $240,000 ($300,000 less your $60,000 down payment).
The 2nd mortgage is a loan taken out against your home on top of your original purchase mortgage. Whether you qualify depends on several factors, including the amount of equity you have and your current income.
It goes by the name “second mortgage” because in the event your home is foreclosed on, the lender of the purchase mortgage will be paid first. Anything left over goes to the lender of the additional mortgage.
The vast majority of these loans come with fixed monthly repayments and work in the same way as any mortgage.
Rates on a second mortgage are typically higher than the rate on a purchase mortgage.
The reason for a higher 2nd mortgage rate is that the lenders are taking a bigger risk. They know if you go into foreclosure, they will have to stand in line to get paid. Homeowners who go into foreclosure rarely have enough to pay both lenders in full after completing the process.
A conventional double mortgage is not your only option for borrowing against the equity in your home. There are two major types of loans at your disposal.
The right option for you depends on your circumstances and what you need the money for.
A standard home equity loan is your most basic 2nd mortgage option. This is a non-revolving, secured loan. In other words, you borrow a fixed amount, and you pay back that fixed amount until the debt is paid off. It’s the simplest type of option for utilizing equity in your home.
A HELOC loan is a line of credit taken out against the equity in your home. Unlike a standard lending option, this line of credit is a revolving debt.
In other words, when your application for a HELOC is successful, you have access to the money, but you don’t have to take it. Furthermore, if you do borrow, you can pay the money back and borrow more money. It’s like a credit card that uses your home as security.
There is a “draw period,” which is the time you allotted to spend the money on a HELOC. The most common draw period is ten years, which is more than enough for most homeowners. Once the draw period elapses, the HELOC enters into what’s known as the repayment period. During this period, you’re required to pay off the balance plus any interest levied.
Taking out a double mortgage isn’t for everyone. There are specific scenarios where it can be useful, however. Let’s take a look at some of the reasons you might want to consider a second mortgage.
Pay Off Other Debts – Although people say you shouldn’t service debt with more debt, sometimes it’s a smart idea. If you have high-interest credit card debt, a second mortgage will provide a much lower interest rate. Taking out a home equity loan or a HELOC to pay off these high-interest credit cards can ultimately leave you paying off a debt with a much lower interest rate.
Cover Revolving Expenses – Going back to school? Hiring a tutor for your kids? Need funds with daycare expenses? These are just some of the revolving expenses that a HELOC may help you cover.
Home Improvement – Home improvement projects are costly and may require a larger lump sum than you may have available. Tapping into equity can free up additional funding. This can pay in the long-term because many home improvement projects can increase your home’s value (and, therefore, increase your equity).
In short, home equity and the ability to turn it into cash when you most need it are extremely powerful financial instruments.
Like any type of debt, it’s important to calculate the pros and cons of drawing out funds. A 2nd mortgage has a few benefits other lending options may not.
A 2nd mortgage loan comes with many benefits however it doesn’t make it the right financing option for everybody. Here are some of the most common drawbacks of a second mortgage:
Thinking about taking out a double mortgage and wondering if you qualify? Lender requirements always differ, so it pays to shop around. Here are the characteristics held in common by most lenders:
You need some equity in your home. The specific amount you will need depends on how much equity you hold compared to the remaining balance on your purchase mortgage.
Minimum credit score requirements typically start in the 600s however these may change from lender to lender.
A debt-to-income ratio lower than 43% is typically required to ensure you have the means to pay the mortgage back.
Not sure if you’re going to qualify for that home equity loan? Here are some alternatives:
A personal loan from the bank could be a viable option. Banks typically have more stringent requirements but may also allow you to take out an unsecured loan. However, unsecured loans will typically have higher interest rates.
A cash-out refinance may help you replace your current mortgage with a lower rate one, plus allow you to take out a sum of cash at the same time. It’s a great option that lets you roll the cash you took out into the new mortgage. You may also be able to reduce your monthly payments.
If you were planning to take out a loan for a home improvement, it may be best to put your project on hold and save up additional money. This means your renovation will take longer however if you have a low credit score or a lack of equity, waiting could be your best alternative.