Summary: What is a second mortgage and how do they work? When does it make sense to use one? What are the potential risks of using one? These are some of the most frequently asked questions about second-lien financing. Here’s what you need to know, as a borrower.
What Is a Second Mortgage, Exactly?
A second mortgage is a home loan taken out on a property that is already mortgaged by a first home loan. It is a second lien (or claim) on the property. The new lien falls next in line after the existing lien, hence the term second mortgage. They are also referred to as “junior lien” loans.
Homeowners typically use them to finance a major expenditure, such as a home renovation. Some people use them to cover the down payment on a second house purchase. They can be used for a wide variety of purposes, in fact.
There are two basic types of second mortgages:
- HEL: With a home equity loan (HEL), you receive the funds as a single, lump-sum payment. With this option, you get the money all at once, like any other standard loan. It is then paid back in regularly scheduled installments, much like the first mortgage. The interest rates on home equity loans are usually fixed, which means they stay the same over the entire payback period or “term.”
- HELOC: A second mortgage can also be issued as a home equity line of credit (HELOC), which basically works like a credit card. With this option, you do not receive a lump-sum payment. Instead, you spend the money as needed for ongoing purchases, as you would use a credit card. The interest rates on HELOCs are usually variable / adjustable.
With both types of second mortgages, the amount you can borrow will be determined by the amount of equity (ownership) you have in your home. For example, if my home is currently valued at $300,000, and my mortgage balance is $200,000, I have $100,000 worth of equity or ownership in the home. I could borrow against this in the form of a second mortgage.
Most lenders will loan you up to 80% of your available equity, though this is not a hard-and-fast rule. They will secure their “interest” in your home by filing a lien behind the lender who loaned you the money for the actual purchase (first mortgage) of the home. So later on, when you sell the home, both the first and second mortgages will be paid off.
You can also pay off the second mortgage anytime you are financially able to do so. You could also refinance down the road to roll the second and first mortgages together — as long as you are qualified for refinancing.
Why Do People Use Second Mortgages?
People take out second mortgages on their homes for many different reasons. They may use it to remodel a kitchen, pay for a new addition, or put in a swimming pool. Or perhaps they need to pay for college tuition for a child, or for the adoption of a child. They may use the second mortgage to pay for a wedding or a dream vacation. Some people use the loan or line-of-credit to payoff bills and consolidate their debt. There are very few restrictions on how you use the money.
HELs are typically used for a specific project, such as a swimming pool or a home remodeling project. HELOCs are commonly used when a homeowner needs access to cash on an ongoing basis, instead of all at once.
There are several advantages to using a second mortgage. For one thing, the interest paid on the loan or line-of-credit can be used as a deduction on most people’s taxes (refer to the official IRS website for details). In addition, the interest rates on a second mortgage are usually lower than the rates for credit cards, student loans and other types of credit accounts. So you could end up paying much less interest over the long run, when compared to a credit card.
Homeowners who live in a strong real estate market with good appreciation can take advantage of their equity through the second mortgage option. Also, if you have lived in your home for many years, and the value of your home would rise considerably with a kitchen or bathroom remodel, then a second mortgage might be a smart financing idea.
Possible Risks & Disadvantages
With all of this being said, there are certain scenarios where it doesn’t make sense to take out a second mortgage on your home.
The recent economic downturn we’ve seen is a prime example of this. Just before the housing bubble burst, homeowners were taking out second mortgages right and left. The value of their homes increased quickly and dramatically, so they were using their newfound equity to make all sorts of improvements — additions, pools, remodels, etc. Many were even buying cars and second homes with their equity. Then, when the real estate bubble burst, they found themselves with over-improved homes and mortgage balances that were much higher than their home was now worth.
And don’t forget you are securing the second mortgage by using your home as collateral. As the Consumer Financial Protection Bureau (CFPB) warns:
“It is important to know that a major risk with home equity loans or home equity lines of credit is that if you cannot repay a home equity loan or home equity line of credit, you could potentially lose your home because you are using the equity in your home as collateral.”
Here’s what you should take away from this article. A second mortgage can be a useful financing tool in certain scenarios, because it allows you to leverage your home equity at a favorable interest rate. In other scenarios, however, this type of loan doesn’t make sense and might even put your home at risk.