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The phrase itself can be a bit off-putting: a “second mortgage”? If you already have a loan, why would you want a second one?
Well, second mortgages, also known as home equity loans, can be a low-cost form of debt that helps you achieve other financial goals. And at a time when interest rates are historically low and home equity is rising rapidly, it may be worth considering what a second mortgage can do for you.
What is a second mortgage and how does it work?
When people use the term “second mortgage,” they’re usually referring to a home equity loan or a home equity line of credit (HELOC).
“A second mortgage is essentially a loan on your property that ranks second to your primary mortgage,” says Matthew Stratman, chief financial adviser at California financial planning firm South Bay Planning Group.
Second mortgages, whether it’s a HELOC or a home equity loan, allow homeowners with enough equity in their homes to borrow against the asset. Equity is the value of your home calculated by subtracting the remaining loan amount from the total value of your home.
You can’t always borrow the full amount of your home’s value; experts commonly say that only up to 85% is what banks and lenders allow. For example, if your home is worth $400,000, the most most borrowers could borrow would be $340,000. But if you have $200,000 left to pay on your primary mortgage, that would leave you with $140,000 of equity to borrow.
Types of second mortgages
There are two main types of second mortgages: a home equity loan or a home equity line of credit (HELOC). A home equity loan allows you to borrow a lump sum of money at one time. Meanwhile, a HELOC works more like a credit card, allowing you to spend your balance up or down and pay only for what you use.
Here’s a more detailed breakdown of how each type of second mortgage works.
Home Equity Loan
A home equity loan works much like your primary mortgage. To qualify for one, you must provide the lender with all of your personal financial information. The lender will assess the value of your home and tell you which home equity loan you qualify for. You can then withdraw that amount of money as a lump sum of cash, to be paid back over 20 or 30 years with interest.
One of the biggest benefits of home equity loans is low interest rates, says Stratman. Compared to credit cards and personal loans, mortgage loan rates are typically lower. Therefore, home equity loans may be ideal for home renovation projects that require a lump sum up front, but could increase the value of your home in the future.
“The best way to use the equity in your home … would be if you’re actually using it as something that adds future value to your property,” says Stratman.
Home equity loans are also a great tool for debt consolidation, says Jodi Hall, president of Nationwide Mortgage Bankers. If you have a fixed amount of debt in the form of student loans or credit cards, you can use the lump sum of cash from a home equity loan to pay off the other debt in one lump sum.
“That’s when a home equity loan is more favorable than a home equity line of credit,” says Hall.
However, there are some drawbacks to home equity loans. First, they add to your overall debt load, which can be risky if you don’t use it wisely or pay it off on time. You’re also adding a second loan payment to your monthly bills. And when you get a home equity loan, you automatically start making payments on the full balance, even if you don’t spend all of the money right away.
A HELOC is a form of revolving credit, somewhat like a credit card. You would apply for a HELOC the same way you would for a home equity loan, and the lender would give you an upper limit on how much you can spend. Your credit limit is likely to top out at 85% of your home’s value or less. Lenders take into account your credit history and factors like income when assigning your limit.
During the “draw period”, you can spend up to your limit. When the draw period ends, you must start paying the amount you used.
“A home equity line of credit is really good if you want the availability to access it, but you may not know when you’ll need it,” says Stratman.
HELOCs can be helpful if you need to fix an emergency roof leak, for example. But they can also be a good tool for larger, planned home renovations.
“Home equity lines of credit are a good thing when you’re doing, say, a remodel, where you may need different amounts of money throughout the process,” says Hall.
But be careful not to treat a HELOC too much like a credit card, Stratman cautions. The money should be used for productive investments that potentially return more than you pay in interest.
Hall agrees: “I would warn people [against] using the equity in the house for their daily expenses,” she says.
Second Mortgage vs. Refinancing
Home refinancing is another common method of managing major expenses or strengthening your financial foundation. Second mortgages are not the same as refinancing. Both can help you save on interest in two different ways.
Refinancing is when you essentially reset your primary mortgage, often with a lower interest rate or better terms. In contrast, you only save on interest with an arbitrage second mortgage, which means you use the money borrowed from the second mortgage to pay off high-interest debt or buy something you otherwise would have used a credit card for. high interest.
Sometimes you can access a cash-out refinance, where you take advantage of your new home equity and get a lump sum of cash by increasing your mortgage loan closer to its original amount.
“If you have an immediate need for money today, that cash-out refinance could serve a purpose,” says Stratman. Also, the interest rates on a cash-out refinance, because it involves your primary mortgage, are generally lower than the interest rates on a second mortgage.
Refinancing can be more complicated than a second mortgage and typically has more upfront costs.
Here is how to compare the differences:
Pros and cons of a second mortgage
Second mortgages can serve many different purposes, but you also need to be aware of some of the risks and shortcomings.
Lower interest rates than other forms of debt, such as credit cards or personal loans.
It can allow you to invest in your home and create more long-term value
HELOCs are flexible and you only pay for what you use
Added to the total amount of your debt
Add another loan payment to your monthly bills
HELOCs, if you’re not careful, can tempt you to live beyond your means
Adding a second mortgage payment can be more expensive than simply doing a cash-out refinance on your primary mortgage
When should you consider a second mortgage?
One of the best times to consider a second mortgage, Stratman says, is if you’re planning a major home renovation. Installing a new kitchen or adding a new bedroom, for example, are investments in your home that are likely to increase its value significantly and are a sound use of your real estate equity.
You can also consider a home equity line of credit to prepare for unexpected housing costs. Especially in older homes, leaky roofs or old heating systems can lead to costly repairs. Securing a HELOC could give you a way to pay for it at a much lower interest rate than a credit card or personal loan.
“It really offers peace of mind,” says Hall.
Second mortgages are not only useful for home investments, they can also be a great way to consolidate other high-interest debt.
But home investments aren’t the only reasons to consider a second mortgage: “Debt consolidation is one way people can use it wisely,” says Stratman.
Here’s how it might work: Let’s say you have a credit card balance of $15,000 with an interest rate of 18%. You could pay off the credit card with money from a second mortgage, which would have a significantly lower interest rate and end up saving you money in the long run.
To be sure, there are also some scenarios where you shouldn’t use a second mortgage, Stratman and Hall said. If you’re having a hard time keeping up with your finances because you’re living beyond your means, a second mortgage will only compound the problem and increase your debt load. Don’t use the money for a big lifestyle purchase — say, a fancy boat or car — that you couldn’t otherwise afford.
“The main thing is that if you are accessing money, try to use it in the most productive way possible without capital money financing your lifestyle. If used responsibly, it can be a good idea,” says Stratman.