How Does A Second Mortgage Work?

If you’ve ever sought out personal financing options, you’ve probably been pointed in the direction of a home equity loan or a home equity line of credit. Both of these financing programs are forms of second mortgages. They allow you to tap into the equity in your home to cover your expenses.

It is important to know how a second mortgage works, and if a second mortgage is even a good idea. Read more to determine whether a second mortgage is right for you. 

First, because the second mortgage is based on your home’s equity, it will always be smaller than your primary mortgage. Second, you’ll be using your current home as collateral for your second mortgage.

On top of that, interest rates can sometimes be higher. The term “second mortgage” actually refers to the order in which lenders are paid during a foreclosure. Since your first mortgage has a higher priority, it means lenders may not get paid at all. The higher interest rate is a protection put in place against that risk. 

Why Get a Second Mortgage? 

Home Improvements 

A second mortgage will provide access to a lot of money at once. It can be ideal to put it toward home improvements. You’ll eventually see a high return on your investment because you're sinking money directly into your home. This is especially possible if you plan to eventually sell your home. 

Down Payment on a Second Home 

If you’re purchasing an investment or vacation property, you can use a second mortgage to cover the down payment. In doing so, you’ll ensure that you have enough for a full 20% down payment. You will also avoid the cost of private mortgage insurance (PMI) which can add to your monthly payments. 

Pay Off Debt 

A second mortgage can be used to consolidate or pay off your debt. This includes student loans and credit card debt. Doing so can be an ideal solution when mortgage rates are low, as they can help you pay off your debt faster without paying excessive interest. 

Second Mortgage: Pros and Cons 

As with any type of financing, there are advantages and disadvantages to taking out a second mortgage. Some of these may depend on your lender. 

Advantages of a Second Mortgage 

Second mortgages offer several advantages: 

• Large loan amounts 
• Flexibility in spending the money 
• Flexible options for receiving funds (lump sum, line of credit) 
• Interest payments may be tax-deductible 

Tax advantages depend on how funds are used. Homeowners who use a second mortgage for substantial home improvements can deduct the interest payments from their annual income taxes. 

Disadvantages of a Second Mortgage 

A second mortgage does come with some potential downsides, such as: 

• Lengthy application and approval process 
• Additional closing costs 
• Putting your home at risk if you default on the loan 
   

If you’re still paying the original mortgage on your home, a second mortgage means you’ll have another mortgage to pay each month. This can be hard to keep up with unless you plan your budget carefully.

Types of Second Home Mortgages 

How does a second mortgage work? The answer depends on which type of mortgage you’re pursuing. There are two basic types of second mortgages, home equity loans or HELOCs, each of which works a bit differently. 

Home Equity Loan 

One of the most direct forms of a second mortgage is a home equity loan. This loan functions similarly to your original mortgage, though it will have a different loan term, loan amount, and interest rate.  

A home equity loan allows you to cash in on a portion of the equity in your home through a lump-sum payment. You’ll be responsible for repaying the loan just like any other mortgage. The loan terms range from five to 30 years. You’ll also be responsible for paying the closing costs, which are usually 3% to 6% of the loan amount. 

Home Equity Line of Credit (HELOC) 

Some homeowners may choose to tap into their home equity on a rotating basis using a home equity line of credit (HELOC). This functions very much like a consumer credit card. In fact, some lenders will even issue you a credit card to make purchases. The credit limit is based on the amount of equity you have built up in your home. 

As long as you repay the balance, you can continue using your HELOC as many times as you need. This makes it a great option for open-ended home improvement projects that don’t have a clear budget. 

However, you may only use a HELOC during the initial draw period. Just like a credit card, you’ll be required to make minimum monthly payments on any money you borrow. Once the period ends, you’ll be responsible for the total loan amount.  

Qualifying for a Second Mortgage 

Though the process of applying will be very much like your first mortgage, actually qualifying for a second mortgage will require additional criteria. For one, your lender may expect you to have a credit score of 620 or higher in order to receive the fairest interest rates and terms. 

You’ll also need to have enough equity built up in your home. Lender requirements can vary, but some will expect you to keep around 20% of your home’s equity in your home. This means that the maximum you can borrow against your property will only be 80% of your home’s value.

Other lenders have different standards, of course. Some may be willing to loan you up to 100% of the equity in your home. 

Alternatives to a Second Mortgage 

A second mortgage isn’t for everyone. Some homeowners may be cautious about the potentially high-interest rates and the idea of using their homes as collateral. If you’re interested in other financing options, you might consider the following: 

Cash-Out Refinance

When you refinance your home, you’re replacing your current mortgage with a brand-new one. A cash-out refinance allows you to take out a new mortgage that’s higher than the value of your home. You’ll receive the excess as a lump-sum cash payment. You can use it for home improvements, debt consolidation, and other expenses. 

Home Improvement Loan 

Home improvement loans also provide the financial means to complete such projects. Although it’s still important to weigh the subtle differences between these loans and second mortgages. Some loans come with high APRs, origination fees, and other financial pitfalls.  

Financing that Fits 

Some of the details regarding how a second mortgage works will depend on the type of loan and your lender. In general, it can be an effective way to tap into your home’s equity to cover much-needed expenses.

If you’re curious about your financial options, contact the team at CrossCountry Mortgage or start your online application today. We’d love to discuss your options and find a solution that fits you and your budget. 

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