When and why would I need a second mortgage?

Published September 11, 2020
by Better

Second mortgage

If you’re already paying off one mortgage, you may wonder why some lenders invite you to take out another. The term, “second mortgage” makes it sound like you're trying to finance a vacation home or an investment property in addition to your primary residence. In truth, a second mortgage is a loan that is taken out on a property that is already mortgaged. The most common kind of second mortgage is a loan that uses the equity you’ve built in your home as collateral to borrow a new sum of money.

When we say, “equity,” we’re talking about the current value of your home, less what you still owe on your mortgage. In other words, it’s the portion of your home that you actually “own.” If your home is worth $500,000 and you have $300,000 owing on your mortgage, then you have $200,000 in equity. Because equity is an asset, it’s possible to use it as collateral and turn it into cash—thus, “second mortgage.”

How does a second mortgage work?

Homeowners who take out second mortgages usually do so to pay off other debts. For example, let’s say you have a high student loan bill due and you don’t have the money to pay it. You do, however, have $150,000 in equity from your home. In this instance, you could use your home to take out a second mortgage to help pay your bill.

There are 3 kinds of second mortgages: home equity loans, home equity lines of credit (HELOCs), and piggyback loans. All 3 have the same intended purpose—to provide you with a substantial amount of money to make a large purchase or pay off significant debts—but there are some important distinctions between each.

Home equity loans

A home equity loan works as you may expect: your lender gives you a lump sum equivalent to a portion of your equity. You can borrow up to a total of 80% of your home’s value, between your second and primary mortgage. In other words, you won’t be able to take out a loan that’s equal to the amount of your home that you own.

Home equity loans are the most straightforward kind of second mortgage. They typically have a fixed interest rate and a loan term that lasts between 5 and 15 years. You make payments every month like you do with your primary mortgage, and you don’t need to explain how you plan to use the money.

With that said, home equity loans do have their drawbacks. For one thing, many lenders have a $25,000 minimum for the amount you can borrow. You’re also likely to be on the hook for many of the standard closing costs associated with a primary mortgage—such as loan origination fees and processing fees.

Home equity lines of credit (HELOCs)

A HELOC uses your equity as a line of credit, and you can borrow as you please over the draw period instead of withdrawing a lump sum. Think of it like a credit card; you’re borrowing money over time in return for paying a fee (interest). Your lender may even give you a physical card once you’re approved. The only real difference between HELOCs and credit cards is that HELOCs have a “draw” period and a “repayment” period. You can only borrow funds during the draw period, and you must pay back your remaining debt with interest during the repayment period.

HELOCs almost always have variable interest rates, which are tied to a benchmark rate and usually include a lender's margin as well. That means that when interest rates go up, your monthly payments go up, too.

Piggyback loans

Piggyback loans are distinct from HELOCs and home equity loans in that they do not use your equity as collateral. In fact, a piggyback loan is a second mortgage that you apply for at the same time as your primary mortgage, i.e. before you have even built any equity. Piggyback loans get their name from being “piggybacked” on top of your primary mortgage if you can’t afford to put 20% down but also want to avoid private mortgage insurance (PMI)—a requirement for smaller down payments.

For example, if you had saved enough to put 10% down on a home, you may decide to take out a piggyback loan for another 10% of the home’s value—increasing your down payment to 20%. This scenario is known as 80-10-10, although other combinations are possible (such as 80-15-5).

Piggyback loans are also an option if you want to purchase a home that exceeds the Fannie Mae, Freddie Mac, or FHA maximums for conforming loans, but don’t want to take out a jumbo loan. Jumbo loans often carry higher interest rates, so you can borrow across two loans in order to qualify for a conforming loan and still afford the house.

However, keep in mind that by taking out a piggyback loan you’re increasing your debt and you'll have additional closing costs to pay. They also typically have higher interest rates.

What are the pros and cons of taking out a second mortgage?

Pros of a second mortgage

Second mortgages can be useful for paying debts or making purchases—including medical bills, consolidating debt, making home improvements, or putting aside an emergency fund. One of their advantages is that their interest rates are lower than credit cards and personal loans because they’re backed by your home, which makes them less risky for lenders.

Cons of a second mortgage

Second mortgages might sound tempting, but they are certainly not for everyone. While second mortgages do allow you to transform your home equity into cash and use it to pay for big purchases you may need, you are still turning your equity into debt that will have to be paid back with interest. In the long term, you will be paying more because of accrued interest and having multiple forms of debt. You are also more vulnerable to default on your loans in the event of a financial crisis, such as losing your job.

The consequences of missing a second mortgage payment are also worse than with your primary mortgage. Your lender can file a personal lawsuit against you or foreclose on your home if you stop paying—so spending on non-essentials can be dangerous. Doing so will also negatively affect your credit. In addition, second mortgages make it more difficult to refinance and come with expensive closing costs.

Is a second mortgage right for me?

Taking out a second mortgage is never an easy decision. While offers with low interest rates sound enticing, a second mortgage shouldn’t be seen as a go-to solution for just any purchase. Bottom line: it’s still debt, and what you intend to use it for matters.

Requirements to qualify for a second mortgage are also strict, due to the increased risk associated with taking on more debt. You’ll need to have sufficient equity—at least 15% to 20% of your home’s value, depending on the lender—a debt-to-income ratio between 43% and 50%, (even if you plan on using your second mortgage to pay off said debt), and a minimum credit score of 620—if not higher.

Better Mortgage does not currently offer second mortgages, but we do have alternative ways you can use the equity in your home to finance a big purchase. Learn if a cash-out refinance is right for you, and get pre-approved in as little as 3 minutes.

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