Second Mortgages: What Are They, and How Do They Work?
02/19/2019 Jerrica Farland
Second mortgages can be a great way to use the equity in your home to free up cash for important needs. Just like any other loan, there are some important things you should know about second mortgages before you begin the application process.
What Is a Second Mortgage?
A second mortgage is generally when you borrow against the equity of your home, and your home is used as collateral for the loan. This loan is called a “second mortgage” because you already have an existing loan on your property. Second mortgages are often easier to qualify for than other types of loans, and they are often used to secure funds for a variety of uses.
How Does a Second Mortgage Work?
A second mortgage requires that an additional, or second, mortgage be taken out on a property that is already mortgaged.
There are two types of loans that generally fall under the broad, informal category of “second mortgage,” a home equity loan and a home equity line of credit. Both of these use your home as collateral, but there are some nuances between them. Let’s take a look at each.
- Home Equity Loan. A home equity loan is a traditional loan, meaning that a fixed amount is lent to you for a fixed term with payments amortized or spread over the life of the loan. You receive all your money in a lump sum when the loan closes.
- Home Equity Line of Credit. A Home Equity Line of Credit (HELOC) allows you to draw money as you need it, up to the maximum amount of your credit line, for a certain amount of time — the draw period. During the draw period, payments are typically interest only. Once the draw period ends, your payments are principal and interest and are amortized over the remainder of the loan term.
How Do I Get the Money?
There are two different ways you can receive the funds from your second mortgage and how you receive your funds depends on if you have a home equity loan or a HELOC. Know the difference between a home equity loan and a home equity line of credit.
Lump Sum. A home equity loan is a standard second mortgage, a one-time loan that provides a lump sum of money that you can use for whatever you wish. With this type of loan, you repay the loan over time, normally with fixed monthly payments. Incorporated into each payment is a portion of the interest, as well as a portion of your loan balance.
Credit Line. With a HELOC, you can get a lump sum of money at one time, and you can have a pool of money that you can draw from over time. With a HELOC, you may be required to take out an initial draw (a lump sum paid out at the time the line is opened), but you also have the option to access additional funds if you want to at a later time. Your lender sets a maximum borrowing limit, and you can continue borrowing (multiple times) until you reach your credit limit. Just like with a credit card, as long as you haven’t maxed out your line, you can borrow over and over on a HELOC.
Common Ways to Use a Second Mortgage
There are many ways to use your second mortgage. For example, some people take out a second mortgage to obtain cash for a large purchase or expense, while others use the money to pay off debt. Some of the most popular ways to use a second mortgage include:
- Paying for home improvements. A second mortgage provides an opportunity to reinvest in your home. Making significant home improvements is generally considered the soundest reason to acquire such a loan because the value of the home should increase and reflect your financial investment.
- Funding an education. The equity in your home can provide a substantial loan to fund educational opportunities for yourself or your children.
- Covering healthcare costs. Unexpected health care costs can cause significant financial strain. A second mortgage may offer a lower-interest loan option than other loans available.
Advantages to a Second Mortgage
Second mortgages are very popular among homeowners because they have benefits that other loans often do not offer.
Access Large Loan Amounts. Depending on how much equity you have, you may have access to fairly substantial amounts of money.
Get Lower Interest Rates. Some second mortgages come with a fixed interest rate that helps you plan your payments for years to come. Variable rate loans are also available and are the norm for HELOCs. Generally, because these loans are secured by your home, the interest rates are lower than many other options.
Tax Deductible. The interest on your loan might be tax-deductible. However, the Tax Cuts and Jobs Act eliminates the deduction unless you use the money for "substantial improvements" to a home for tax years after 2017.
*Consult a tax adviser for further information regarding the deductibility of interest and charges.
Retain low interest rate first. Since your second mortgage is separate, your payment will also be separate– giving you access to your equity, while letting you keep your current mortgage’s low rate.
Want more info on how the Tax Cuts and Jobs Act affected homeowners’ deductions? We compiled a range of insights from tax and financial experts.
Disadvantages to a Second Mortgage
All loans have some disadvantages and it’s important to understand the ones specific to second mortgages and how they might impact you.
An Additional Monthly Payment. While a second mortgage doesn’t have an impact on your current mortgage payment, it will be a separate payment that you’ll need to account for in your monthly budget.
Closing Costs. Second mortgages usually require credit checks, appraisals, and origination fees. Make sure you fully understand all the costs associated with a second mortgage, especially ones that might be less transparent or hidden.
Potentially Higher Interest Rates. While second mortgage rates may be slightly higher than the rate on your original loan, they are often much lower than credit card interest rates.
Do I Qualify for a Second Mortgage?
To get a second mortgage, you need to have a certain amount of equity in your house. You can build equity by having a larger down payment when you purchase your home, making monthly mortgage payments, and when your home’s value appreciates. Lenders will require that the amount of your first and potential second loans do not exceed a limit of 85% of the appraised market value of your home. This is called a combined loan-to-value (CLTV) ratio, a variant of the more common LTV ratio. You’ll, of course, need to have equity in your home in order to access it.
CLTV is calculated by taking your existing mortgage balance(s) plus your desired loan amount, divided by your home value:
>CLTV = (Loan Amount + Total Mortgage Balances) / Home Value
Tips for Taking Out a Second Mortgage
If you think a second mortgage is a good option for your situation, here are some tips to get you prepared for the next steps.
- Make a financial plan. There are several things to consider before you take out a second mortgage. For example, what will you do with the money? What will your payment plan look like? Will you have the financial flexibility for emergencies? Planning ahead of time will help ensure that you make the best financial decision possible.
- Know your credit score. Depending on your credit score, you may have more options and lower interest rates. It’s important to know your credit score when you’re taking out a second mortgage so you can find the loan and lender that’s best for you.
- Get your documents organized. In order to apply for a second mortgage, you need to provide documents — sometimes even more than you needed to for your first mortgage. While you may be asked for additional documents, the following documents are always necessary and having them prepared ahead of time will speed up your application.
- W2 earnings statements or 1099 income statements for the last two years
- Federal tax returns for the last two years
- Bank statements for the last few months
- Recent paycheck stubs
- Proof of other income, such as tips, Social Security payments, investment income, etc.
Exploring Your Options for a Second Mortgage
The bottom line is that while second mortgages are common and convenient, it’s important to determine if they’re a good fit for you. If you are ready to apply, get started by contacting a PennyMac Loan Officer to learn more about the second mortgage options available to you.