Ready to remodel your kitchen? Or maybe you'd like to pay off all those high-interest credit cards. If so, you may be living in the best source of funds to accomplish those objectives: The equity in your home. It could be the largest source of cash reserves that you can easily access. Maybe you should consider taking advantage of this equity reserve with a second mortgage.
But before you get started, consider the various types of second mortgages and the pros and cons of each one.
What is a Second Mortgage?
A second mortgage is a loan secured by your house that already has a first mortgage. The equity in your house is used as collateral for the second mortgage. You’re borrowing against the equity you have gained in your house by paying down your first mortgage or from an increase in the market value of your home.
For example, if your home has a current market value of $250,000 and you owe $100,000 in a first mortgage, then you have equity in your home of $150,000 ($250,000 less $100,000).
The interest rates on second mortgages, which are secured by the equity in your home, will generally be higher than the rate on your first mortgage but lower than rates on credit cards and personal loans, which are unsecured. Therefore, it sometimes makes sense to replace high-interest debt with the lower interest cost of a second mortgage.
Interest rates on second mortgages are higher than the rate you have on your first mortgage because the second mortgage lender is in an inferior position and has more risk. If your house goes into foreclosure, the lender for your first mortgage will get paid first from the proceeds of the sale, and the second mortgage lender will get whatever funds are left.
Second mortgages come in two types: a home equity loan and a home equity line of credit
Read more: Stand-Alone Second Mortgage Definition
What is a Home Equity Loan?
A home equity loan is a second mortgage that gives you a lump-sum of money and has fixed monthly payments at a fixed rate over several years. The terms range from five to 30 years.
A home equity loan is a good option to consolidate your other debts, like high-interest credit card balances, or to use for a home improvement project, such as remodeling a kitchen.
An advantage of a home equity loan is that you get all of the money upfront. Getting the money all at once is helpful when you are using the funds for a single purpose.
A disadvantage of home equity loans is that they come with closing costs, which can add 2 percent to 5 percent to the cost of the loan. You may have to pay for a new appraisal, origination fees, title search and other lender fees.
Another issue to consider is that by using the equity in your home as collateral, you put your home at risk if you miss payments and the bank initiates foreclosure actions. You already have a fixed commitment to make monthly payments on your first mortgage, and you may not want to add another payment to your total debt obligations. This is a reason to make sure your debt-to-income ratio does not get too high.
What is a Home Equity Line of Credit?
A home equity line of credit (HELOC) works like your credit cards. You have a maximum line of credit that you can borrow as much or as little as you need and whenever you want. A HELOC makes sense if you want the flexibility of borrowing money only when you need it. For example, you may have an ongoing project, like remodeling a kitchen, but aren't sure how much cash you will need – and when – if you’re doing the project in phases.
HELOCs usually have two time periods: a period for a drawdown of the funds and a repayment period.
Drawdown periods usually last up to 10 years. During this time, you will likely only be required to make interest payments on the funds that you have taken.
When you enter the repayment phase, you will begin making payments on both principal and interest. With some HELOCs, repayments can be spread up to 20 years.
A disadvantage of HELOCs is they have variable interest rates that fluctuate with changes in the prime rate. This can make it difficult to budget your payments and could put a strain on your cash flow if interest rates shot up suddenly and your required monthly payment increased substantially.
With HELOCs, lenders may charge you yearly membership and maintenance fees. There could also be other fees for minimum withdrawals, early termination or inactivity if you don’t use the line of credit.
Read more: How to Qualify for Two Mortgages
How to Qualify for a Second Mortgage
Lenders look for borrowers that meet the following requirements:
- Proof of stable income and employment – Lenders will look at your income to determine your ability to make the loan payments.
- Minimum of 15 to 20 percent equity in your home – The amount you can borrow depends on how much equity you have in your house. Plus, having enough equity provides a cushion for both yourself and the lender to prevent you from going underwater with your mortgages in the event market prices go down.
- Credit score mid-600s or higher – Some lenders have minimum credit score requirements starting around 620. Higher scores will get you lower interest rates.
- Debt-to-income ratio of 43 percent or less – Borrowers with lower debt-to-income ratios will get approved more easily and may receive lower interest rates.
- Consistently good payment history – You can demonstrate to the lender that you're a low-risk borrower by having a record of paying your bills on time.
Uses of Second Mortgages
These are a few reasons to take out a second mortgage:
- Pay off other debts with high interest rates, such as personal loans and credit cards
- Pay for home improvements, like adding an outside deck or updating bathrooms
- Paying off the bills from an emergency such as medical issues or having to make unexpected expensive repairs on your car.
- To finance a vacation, wedding or make another type of large purchase, such as furniture
Using a second mortgage on your house to buy investment property can be risky because a downturn in the housing market could result in a decline in the value of both properties. If that happens, you could wind up with mortgage debt that exceeds the value of the underlying properties, which would include your own house.
The best use for funds from a second mortgage is anything that adds to the value of your home or will lead to additional income for your household.
Read more: Definition of a Closed-end Second Mortgage
Does a Second Mortgage Have Tax Benefits?
The interest on a second mortgage may be deductible on your tax returns depending on the total amount of the mortgages and what the funds were used for.
The Internal Revenue Service allows you to deduct interest on qualified residence loans up to $750,000. The loans must be used to buy, build or substantially improve your main home and second home.
Let's take a few examples to see how this ruling works.
Purchase a primary home and make improvements – Suppose you take out a new $400,000 mortgage to purchase your primary home, which has a fair market value of $700,000. A few months later, you take out a $150,000 home equity loan to add an entertainment room to your house. Since the total amount of the loans, $550,000, does not exceed $750,000, the interest on both loans is deductible. If you had used the proceeds from the home equity loan for personal expenses, such as paying off credit cards, the interest would not be deductible.
Purchase a primary home and a vacation home – Now suppose you take out a new $400,000 mortgage to purchase your primary home and several months later you take out another mortgage for $200,000 to buy a vacation home. This $200,000 loan is secured by the vacation home. Since the total amount of both loans, $600,000, does not exceed $750,000, the interest on both mortgages is deductible.
Note, however, that if you had taken out a $200,000 home equity loan based on the equity in your primary home, the interest on the home equity loan would not be deductible. In this case, the proceeds from the home equity loan were not used to make improvements on the primary home, making the interest ineligible as a deduction.
Second Mortgage versus Refinance
If your original first mortgage has a high interest rate and current market rates are much lower, it may make more sense to go with a cash-out refinance of your first mortgage. You'll have to compare the alternatives for second mortgages, the rates and the amount of the payments. You might find that your payments will be lower by refinancing your first mortgage rather than adding an additional payment from a second mortgage.
On the other hand, a home equity line of credit might be a better choice if you have a series of home projects spread out over several months or years or need money on a recurring basis, such as making tuition payments for college. In this situation, a HELOC might also be a better choice if your first mortgage already has a low rate that is better than current market rates.
How to Get a Second Mortgage
To get a second mortgage, you will have to qualify in much the same way you did when applying for your first primary mortgage.
- Be prepared with your employment and income documents.
- Check your credit score so you're not surprised when the lender shows it to you.
- Do the math on your financial obligations and calculate your debt-to-income ratio.
- Research recent sales in your neighborhood to get an estimate of the equity in your house.
Shop around with several vendors. Check with your local bank and credit union. Ask your real estate agent for a recommendation to a mortgage broker. Preparation is the key to reducing anxiety.
- Rocket Mortgage: hat Is A Second Mortgage And How Does It Work?
- Forbes: Second Mortgage: What It Is And How It Works
- US Bank: Second Mortgage vs. Home Equity Loan
- Bankrate: What is a Second Mortgage?
- the balance: Second Mortgages-Advantages and Disadvantages
- Quicken Loans: Second Mortgages: What They Are and How They Work
- Internal Revenue Service: Interest on Home Equity Loans Often Still Deductible Under New Law
- NASDAQ.com. "JPMorgan Chase Stops Accepting HELOC Applications Due to Coronavirus Uncertainty." Accessed May 9, 2020.
- Wells Fargo. "Covid-19 Update: Answers to Frequently Asked Mortgage and Home Equity Questions." Accessed May 9, 2020.
- United States Congress. "Summary: H.R.1 — 115th Congress (2017-2018)." Accessed May 9, 2020.
- Internal Revenue Service. "Interest on Home Equity Loans Often Still Deductible Under New Law." Accessed May 9, 2020.
- Federal Trade Commission. "Home Equity Loans and Credit Lines: The Three-Day Cancellation Rule." Accessed May 9, 2020.
- Federal Trade Commission. "Home Equity Loans and Credit Lines: If You Decide to Cancel." Accessed May 9, 2020.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.