A Guide to Second Mortgages: Benefits, Pros, Cons
It doesn’t matter how comfortable you are right now, there will always come a time when money is slow, life seems to stagnate, and your bills and debts seem to grow more than your income. If that happens, and you have cleared some equity in your home, a second mortgage can lend a helping hand.
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Second mortgages can tap into the equity that you have earned, providing access to a sizeable sum of money when you need it the most and giving you a low-interest rate in return.
What is a Second Mortgage?
In simple terms, a second mortgage is a lien against a property that already has a mortgage. With a first mortgage, the bank owns all the house minus the share claimed when you made the down payment and successive monthly payments. A second mortgage is levied against the share that you have accumulated and the lender reclaims some of that share if you default on the loan.
As an example, if you make a 20% down payment on your first mortgage and repay an additional 20% via monthly mortgage payments, you have a 40% equity share in the house. You can then take a second mortgage, and a lien will be placed against that share.
If you default on your debts, the first mortgage company will foreclose your home and sell it to the highest bidder. The funds generated by this sale will be used to pay the debt, fees, taxes, and anything else associated with the original mortgage. Whatever is left will go towards repaying the second mortgage.
In exchange for this lien, a mortgage company offers you a cash sum payment, essentially buying your equity share and allowing you to buy it back via monthly payments. You still technically own the house, your name will remain on the deeds, and if you continue to make those payments then that will remain the case.
But as soon as you miss a payment and go several months without paying anything towards the debt, the mortgage company will initiate the foreclosure process.
What’s the Purpose of a Second Mortgage?
Building home equity is the goal of every homeowner, but there are very few things you can actually do with this equity.
If you ever sell the house, having more equity will ensure you get more money, as you’ll have less of a mortgage balance to clear. But if you plan on living there forever then the only difference between 20% and 100% equity is that the latter equates to fewer monthly payments and more inheritance for your heirs.
That’s where second mortgages come in, as they can tap into that equity and give you a cash sum.
The lender offers you a larger cash sum than a traditional personal loan, because they can use your home equity as collateral and know that if anything happens, they can seize money from your estate. When the lender’s liability drops, interest rates soon follow, and home equity loans and second mortgages typically offer very favorable rates when compared to personal loans.
You can use a second mortgage to pay for a sudden and unexpected expense, such as medical bills or a funeral, or you can use them to fund a child/grandchild’s education, a vacation or some home improvements. There are no stipulations on how you spend the money, only that you pay it back on time.
Requirements for a Second Mortgage
There are several different types of second mortgage, and all these have different requirements. We’ll discuss these variations below, but generally, a second mortgage requires you to have a credit score of at least 620 and home equity of at least 20%.
Your debt-to-income ratio will also be considered. This ratio compares your total monthly debt payments (credit card minimum payments, student loans) to your gross income. Debt payments of $2,000 and an income of $4,000, for instance, would equate to a debt-to-income ratio of 50%, which is higher than many second mortgage lenders will accept. Generally speaking, you need a debt-to-income ratio of less than 43% to be accepted.
As for the amount of money you will receive that will depend on the value of your home and your equity share.
Second Mortgage vs Refinance
A refinance and a second mortgage are two different things entirely, each with their own pros and cons. A second mortgage loan gives you a cash lump sum in exchange for new debt, one that requires you to pay an additional monthly payment. It’s a second lien, which means it’s an extra responsibility.
A refinance, on the other hand, clears the loan balance of your first mortgage and applies a whole new set of terms. The first lien is swapped for a new one and the borrower can benefit from reduced interest rates or a reduced/increased term.
A refinance may be taken by borrowers seeking improved rates, or to swap a fixed rate for a variable rate. It can also be taken by borrowers looking to remove Private Mortgage Insurance (PMI) for their mortgage, but unlike a second mortgage, it doesn’t provide homeowners with a cash sum. Both mortgages charge closing costs, including origination fees.
Types of Second Mortgage
There are several types of second mortgages, each offering a cash sum or line of credit in exchange for having a new lien placed against your home. Some of these options require a monthly mortgage payment, others only need to be repaid under specific circumstances.
Home Equity Loan
A home equity loan swaps home equity for a cash lump sum, which can be used for everything from debt consolidation to home improvements and college education. These home loans typically last for between 5 and 30 years and can significantly increase your monthly obligations.
Home Equity Line of Credit
A home equity line of credit (HELOC) works a lot like an equity loan, only it’s released as a line of credit, much like a credit card. There are two periods to a HELOC. During the first, known as a draw period, homeowners can borrow money against the equity in their home, with a limit based on the percentage of equity.
During this time, they are required to pay a fixed sum every month, and when this period ends, all the money must be repaid, either as a lump sum or as part of a repayment plan.
Cash-out refinancing differs from equity loans in that it replaces one loan for another, with the new loan offering a larger sum than needed and paying the extra amount directly to the homeowner. For instance, if you have a mortgage of $100,000 on a $200,000 house, you can take out a loan amount of $150,000 and pocket the remaining $50,000.
It’s generally one of the better options, but its benefits will depend on your home’s value, as well as the mortgage amount and equity.
A reverse mortgage gives you a cash sum and doesn’t require you to make monthly payments in return. You only need to pay off the debt when you sell the house, move or die, but there are some strict requirements regarding how you maintain the property and what you’re allowed to do with it.
These mortgages are only offered to lenders aged at least 62 who own all or most of their homes.
Bottom Line: Cash on Tap
From home equity lines of credit to equity loans and reverse mortgages, homeowners have a wealth of options at their disposal, many of which can be acquired regardless of whether you have an FHA loan or conventional loan. The borrowing limit is based on the market value and your home equity and if you have a good credit score you can negotiate a low-interest rate with the lender.
However, it’s important not to rush into this and to think your decision through carefully. By acquiring a home equity loan or line of credit, you could be placing your hard-earned equity at risk or reducing the amount of money your heirs receive after you’re gone.
If you need a sudden cash injection, make sure you exhaust all other options before considering a second mortgage.