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What is a second mortgage and how does it work? The full breakdown

At a glance:

  • What is a second mortgage?

  • Why take out a second mortgage?

  • What lenders look for when considering second mortgage applications

  • What to look for in a second mortgage

  • Summary of second mortgages

If you are like many homeowners, you may eventually find yourself needing a lot of cash — for any of a variety of reasons — but you (wisely) do not want to tap your credit cards. This is where a second mortgage may come in handy.

A second mortgage is a financing technique that has become an increasingly common option.

Second mortgages are obtained from banks, credit unions, and financing companies. To obtain a second mortgage, you must have a good credit score, be able to make both the first and second mortgage payments, and have a steady income.

While second mortgages can allow you to ease your financial situation by accessing equity in your home, they can also put your home at risk if you have a problem in the future making your payments. Like other financing options, second mortgages are one way for you to borrow money for a variety of purposes.

A sign indicating a "Sold" house sits atop a realty company's lawn sign in Brandon Miss., Wednesday, Sept. 25, 2019. (AP Photo/Rogelio V. Solis)
A sign indicating a "Sold" house sits atop a realty company's lawn sign in Brandon Miss., Wednesday, Sept. 25, 2019. (AP Photo/Rogelio V. Solis)

What is a second mortgage? Here are the basics

A second mortgage is a subsidiary loan on your home.

Generally, the holder of a first mortgage has the right to repossess your home if you default on your payments. The rights of the second mortgage holder are secondary to those of the first mortgage holder.

Second mortgages are usually smaller amounts than first mortgages, generally in the range of 10–20 percent of the home's appraised value.

How they compare to home equity lines of credit

Second mortgages are similar to home equity lines of credit in that they are both subordinate to the first mortgage and are usually for a much smaller amount than the first mortgage. There are differences. A second mortgage is generally paid out in a lump sum, while you can draw on a home equity line of credit gradually through a checkbook tied to that account.

Both second mortgages and home equity lines of credit have shorter durations than first mortgages — many have 10–15 year lives when you are required to make payments that at least cover the interest due. The payments for both may include principal plus interest, or may be "interest-only," calling for a balloon payment at the end of the loan term.

Second mortgages can be either in the form of fixed or adjustable-rate mortgages, while home equity lines of credit generally have adjustable rates pegged to a certain index, such as the Prime Rate or the London Interbank Offered Rate (LIBOR), two indexes that track interest rates in the US and overseas.

What is the effect on your equity?

In the case of both a second mortgage and a home equity line of credit, you are tapping equity in your home for other purposes, such as to pay outstanding bills or launch a home improvement project. The larger a second mortgage or line of credit you take out, the less home equity you have as a result.

One disadvantage to consider

One advantage a home equity line of credit often has over a second mortgage is that as you repay the loan, you may gain access to additional credit because the line of credit replenishes itself as you repay principal, which doesn't occur with a second mortgage.

However, lenders can and will trim lines of credit for a number of reasons, but generally will not pull a second mortgage unless you are behind on your payments; so, in an environment where housing prices are falling and lenders are skittish, you might find a second mortgage a more reliable source of funds than a home equity line of credit.

Why take out a second mortgage?

There are several reasons why you might want to take out a second mortgage.

To fill a down payment

If you don't have a down payment that equals 20% of the value of the home you want to purchase, getting a second mortgage can fill this financial shortfall, while eliminating the need for private mortgage insurance. Avoiding this expense can save you thousands of dollars a year in insurance payments.

When you take out a second mortgage for this purpose, the mortgage is structured with an 80% first mortgage and a second mortgage that makes up the difference between the value of the home you are purchasing and your down payment.

To access equity

A second reason to favor a second mortgage is if you need to access the equity in your house but don't want to refinance your first mortgage. This could happen if interest rates have risen since you initially financed your first mortgage, making it unattractive to refinance your first mortgage.

The third major reason borrowers access a second mortgage is to tap equity that has built up in their home — either due to real estate price appreciation or mortgage payments, or both. Borrowers tap equity for many reasons, two of the most common reasons being for home improvements and to pay down debt.

Since debt in the form of primary, secondary, and home equity lines of credit is generally tax deductible, many consumers prefer to consolidate other debt they have by borrowing against their home and paying off the other outstanding debt.

The value of the tax deduction

So the tax deduction that second mortgage interest potentially brings is one major advantage of second mortgages over other financing alternatives. With a fixed-rate second mortgage, you have the certainty of knowing exactly what your payments will be over the life of the loan, whether it be 10 or 15 years.

That's in contrast to an adjustable-rate second mortgage or a home equity line of credit where the interest rate adjusts, depriving you of that certainty.

But there are downsides

The major disadvantage of taking out a second mortgage is that your house is on the line. If you lose your job or encounter some other type of financial difficulty and can't make your payments, you could lose your house. You are also are reducing the amount of equity in your home, which many consumers count on to help them in retirement.

What lenders look for when considering second mortgage applications

When determining whether you are qualified for a second mortgage, lenders examine a number of criteria, including your credit score, debt-to-income ratio, employment history, and current home equity.

As lending standards tightened due to the recent housing crisis, lenders have been much more careful about making loans, especially real estate loans. These days, lenders are seeking borrowers with credit scores close to or above 700. If your credit score is lower than that, you will either be refused for a loan or socked with a much higher rate than prime borrowers with good credit scores.

Your debt-to-income ratio: very important

Another important factor is your debt-to-income ratio, meaning how your various debts compare to how much money you earn. Your lender will calculate this ratio by dividing your total monthly debt payments by your gross monthly income (including taxes). Your total monthly debt payments include all your debts such as your first mortgage, credit card payments, car loan and student loan payments, payday loans, and any other financial obligations you may have.

Two main types

There are two main types of debt-to-income ratios: the first, the front ratio, denotes the percentage of income that goes to pay housing costs, including mortgages' principal and interest, mortgage insurance, property taxes, and condo or homeowners association fees. The second, the back ratio, indicates the percentage that goes to pay all your debts, those included in the front ratio and all others.

Lenders have different standards for debt-to-income ratios, but generally speaking, those for conforming loans — those that can be sold in the secondary markets — have a ratio of 28/36, meaning that your housing-related costs cannot consume more than 28% of your gross income and your total debt can't consume more than 36% of your gross income.

Can you meet those numbers?

Much of your ability to meet those debt ratios depends on your current salary and your spouse's salary (if you have one) as well as how long you have held your job. Lenders also scrutinize the amount of equity available in your home, based on how much you owe on your first mortgage and how much your home would sell for at the time you take out the second mortgage.

What to look for in a second mortgage

Not all second mortgages are created equally. Because you are seeking to take out another mortgage, you will be subject to a similar set of fees that you encountered in your first mortgage.

Obviously, the lower the fees, the better, so you should comparison shop carefully among a number of lenders and obtain your second mortgage from the lender who offers the best terms.

Understand the interest rates

Be prepared to pay a higher interest rate on your second mortgage than on your first. Because second mortgages are subordinate to first mortgages, lending institutions consider them more risky, so they charge a higher interest rate.

Still, it pays to shop around because one lender may offer you a better interest rate than another. Generally, your interest rate will be based on your credit score, job history, and other factors.

Consider points

Most second mortgages carry points, whereby you can buy your interest rate down to a lower level by paying an up-front fee. In this case, one point equals 1% of the value of your second mortgage, two points equals two percent, and so on. Other fees you are likely to encounter include appraisal fees, application costs, and closing costs, all of which will increase your costs.

Some common closing costs

Typical closing costs include origination fees, lender processing and underwriting fees, credit report, title insurance, reconveyance fee, recording fee, title closing fee and title document preparation fee.

Lenders are required to provide you with an itemized list that estimates your closing cost prior to closing, although your actual closing costs may differ at closing. Sometimes loans also come with repayment penalties, hefty fees for late payments, or balloon payments at the end of the loan.

Summary of second mortgages

A second mortgage can be a useful financing vehicle to pay off debts, pay college tuition, or finance an addition to your house. When considering a second mortgage, be sure to consider its merits versus a home equity line of credit. Also, compare rates and fees at several banks, credit unions, and financing companies to get the best deal.

Before applying, get a copy of your credit report and credit score and fix any errors that may appear on your report. Lastly, remember that when you take out a second mortgage, you are tapping the equity in your home, so borrow only for necessary expenses.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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