A Guide to 2nd Mortgages: What You Need to KnowTetyana Artemova
When you want cash to pay off your debt, cover medical bills, send your kid to college, or renovate your home, you can consider getting a second mortgage. This type of mortgage is available to a homeowner with enough equity in their house.
If you’re considering taking a 2nd mortgage, there are things you need to understand first. In this guide, we tell you everything you need to know about a second mortgage and how it works.
What Is a Second Mortgage?
A second mortgage is a type of loan that allows you to borrow against your property’s equity. The lender uses your home as collateral, giving them the right to possess and seize the property if you fail to repay the loan.
Homeowners prefer second mortgages over cash-out refinance because you have the option to withdraw equity without replacing your entire mortgage at a higher rate. However, the second mortgage carries a higher interest rate than the first.
A second mortgage gives you control over how you want to use the money. For example, you can use it:
- to pay off debt
- as a down payment
- to invest in a business
- to finance education, vacation, wedding, or medical bills
- for home improvement
Unlike other types of loans, like student loans, a second mortgage can be used for almost anything. But we should point out that some lenders restrict how you use your second mortgage funds. For example, they may not allow you to buy firearms or gamble with the proceeds from the 2nd mortgage. Others won’t allow you to start your own business.
Pro tip: Before applying for a second mortgage, it’s advisable to inquire about the restrictions imposed on how you can use a second mortgage.
There are two main types of second mortgages:
- Home equity loan. A home equity loan provides a lump sum of money you can use for whatever reason. The loan comes with a fixed rate, and the repayment period is predetermined, often with fixed monthly repayments.
- Home equity line of credit (HELOC). With a HELOC, instead of borrowing a fixed amount, you set a line of credit that you can draw against when the need arises. The lenders take a lien against your property upfront, but you aren’t required to take any money – although you have the option to do so. The lenders set a maximum borrowing limit, and you can borrow multiple times until you exhaust the limit.
How does a 2nd mortgage work?
As the term suggests, a 2nd mortgage is granted after you’ve already taken the primary loan to purchase the property. Over time as you make your monthly repayments to reduce the first mortgage, your home equity grows.
Your home equity is the home’s market value, less any loan balances.
There are other factors that contribute to increasing your home equity. If the real estate market experiences strong gains, or you make improvements to your home, your equity grows as well.
You can then decide to borrow against your home equity, or in other words, use the money tied up in your property to settle your financial issues. That becomes the second mortgage. The lender makes a lump sum payment to the borrower upfront and specifies a repayment term. The interest rate can be fixed or variable, depending on the loan agreement.
To qualify for a second mortgage, the lender will require certain conditions to be met. The most basic requirement is that you have enough equity built up in the property. The terms and requirements vary from one lender to another, but basically:
- You can borrow up to 85 percent of your home’s value, less your current mortgage debts. For example, say your home is worth $250,000 and $150,000 is remaining on your mortgage, you can borrow up to $62,500: [($250,000 x 0.85) – $150,000].
- The amount you borrow can’t exceed the loan-to-value (CLTV) ratio limits. The lender will add the balance of your first and second mortgages to determine your CLTV. The balance on the first mortgage should be less than 85 percent of the home’s value
- You’ll need a credit score of at least 600. Other lenders may require a higher credit score of at least 680.
- A debt-to-income (DTI) ratio of 43 percent. To calculate your DTI, divide your total monthly debt (including both mortgage payments) by your gross income.
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2nd home mortgage rates 2023
2022 was a tough year in real estate, with home financing costs doubling. But the last two months have seen some steady decline in rates, spelling some relief for potential homebuyers.
According to a recent forecast by the financial services website Bankrate, “the benchmark 30-year fixed-rate mortgage is averaging 6.13 percent (as of January 31), up 2.58 percent from a year ago but down from its 7.08 percent high last autumn.”
Economists and financial advisors are positive that the mortgage rates will continue their downward track in February, and the months to come. This is good news, not only for homeowners with first mortgages, but also those wanting to take second mortgages.
While 2nd mortgage rates are usually higher than primary home rates, the margin isn’t big and can range from 0.50%, 0.75%, to 1% higher.
How to get a 2nd mortgage
The process of applying for a second mortgage is essentially similar to that of any mortgage approval:
- Your first step is to shop around to find lenders with the most favorable terms. This could be a bank or credit union. If you already have an existing relationship with a lender, that’s a great place to start.
- Once you identify a lender and are satisfied with their quote, you can apply for a loan. Each lender has a unique application process and may ask for different documentation. Therefore, it’s wise to have all the necessary documents ready, as it makes the process easier and less stressful. Some of the information you’ll be asked to provide include mortgage balance, income, credit report, etc.
- Get your home appraised and inspected as required. Your lender will likely want to get your home appraised to determine the property’s value and equity. This will help them determine the amount of loan you qualify for.
- Close and secure your second mortgage. Once everything is in order, the lender approves the loan and starts processing it. Like any mortgage, the approval time for a second mortgage may vary from one lender to another. It may take your lender’s underwriter a few weeks to review your loan application.
Keep in mind that you can borrow up to 80-85 percent of your home’s value.
It’s also worth noting that second mortgages attract some fees. These include origination fees, appraisal fees, and costs to run a credit check, among others. In some cases, you even finance closing costs.
Second mortgage FAQs
What is a second mortgage?
A second mortgage is a loan you take on top of your existing mortgage. It allows you to utilize your home equity to acquire funds for personal use. The amount you can borrow is determined by your home’s value, which is typically 80-85% when the first and second mortgages are combined.
Can you get a 2nd mortgage with bad credit?
Not likely. However, some lenders can be more lenient depending on your circumstances. Even so, they probably will reduce the amount you can borrow, based on your scores. You’ll require a credit score of at least 620 although some lenders set it as high as 680. Remember, the higher your credit score, the lower the 2nd mortgage rate.
If you have a low credit score but a lot of equity, consider a cash-out refinance.
Is a second mortgage a good idea?
A second mortgage makes sense when you need some amount to cater to pressing financial needs. It also makes sense if you have a high credit score and want to leave your first mortgage as-is.
A second mortgage gives you access to a significant amount of money since your home is used as collateral. Often, you can borrow up to 85 percent of your home’s value, but this will depend on the lender. The maximum amount will be determined by all your home loans, including the first and second mortgages.
In addition, a second mortgage attracts lower interest rates than other types of debt, like personal loans or credit cards. This is because you’re securing the loan with your home, which lowers the risk to the lender.
The Bottom Line
A second mortgage gives you access to funds (held in your home equity) that can help you when in need. However, a 2nd mortgage puts your home at risk of being possessed by the lender if you default. Likewise, the mortgage increases your monthly housing expenses. Therefore, before applying for a second mortgage, be sure to explore all the risks involved and only move forward if you’re certain you can support both mortgages.