Loans

When Should You Take Out a Second Mortgage?

When Should You Take Out a Second Mortgage?
Written by Publishing Team

We want to help you make informed decisions. Certain links on this page, which are clearly marked, may take you to a partner website and may earn you a referral commission. For more information, see How do we make money.

The phrase itself might be a bit of a turn off: “Second mortgage?” If you’ve already taken out one loan, why would you want a second one?

Well, second home loans – 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 have historically been low and real estate equity is rapidly increasing, it can be helpful to think about 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 are usually referring to a home purchase loan or a home purchase line of credit (HELOC).

“A second mortgage is basically a loan on your property that takes second place after the primary mortgage,” says Matthew Stratman, principal financial advisor at California financial planning firm, South Bay Planning Group.

Second mortgages, whether a HELOC or equity loan, allow homeowners who have enough equity in their home to borrow against the assets. 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 total amount of your home’s value – experts generally say that only up to 85% is what banks and lenders allow. For example, if your house is worth $400,000, the maximum amount most borrowers can borrow will be $340,000. But if you have $200,000 left to pay off your primary mortgage, you’ll have $140,000 of capital left to borrow.

Second types of mortgage

There are two main types of second mortgages: a home equity loan or a home purchase line of credit (HELOC). A home equity loan allows you to borrow a lump sum of money at once. Meanwhile, HELOC works like a credit card, allowing you to spend the balance up or down and pay for only what you use.

Below is a more detailed analysis of how each type of second mortgage works.

home equity loan

A home equity loan works much like a 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 how much of the home equity loan you are entitled to. Then, you can have that amount of money as a lump sum of cash, which will be repaid over a period of 20 or 30 years with interest.

One of the biggest benefits of home purchase loans, Stratman says, is the low interest rates. Compared to credit cards and personal loans, mortgage lending rates are usually lower. Therefore, home purchase loans can be very suitable for home renovation projects that require a lump sum up front but potentially increase the value of your home in the future.

“The best way to use the equity in your home…is if you’re already using it as something that adds future value to your property,” says Stratman.

Home equity loans are also a great debt consolidation tool, says Jodi Hall, president of Nationwide Mortgage Bankers. If you have a set amount of debt in the form of student loans or credit cards, you can use the total cash amount from a home equity loan to pay off the other debt in one go.

“This happens when a home equity loan is more appropriate than a home equity line of credit,” says Hall.

However, there are some drawbacks to home purchase loans. First, they add to your overall debt burden, which can be risky if you don’t use it wisely or pay it off on time. You also add a second loan payment to your monthly bills. And when you take out a home loan, you automatically start making the balance payments in full, even if you don’t spend all the money right away.

hello

HELOC is a form of revolving credit, like a credit card. You will apply for a HELOC the same way you would for a home purchase loan, and the lender will give you an upper limit on how much you can spend. Your credit limit will likely be 85% of your home’s value or less. Lenders take your credit history and factors like income into account when setting your limit.

During the Withdrawal Period, you can spend up to your limit. When the withdrawal period ends, you will then be asked to start paying the amount you used.

“A home ownership line of credit is really good if you want to get access to it, but you might not know when you’ll need it,” says Stratman.

HELOCs may be useful if you need to fix an emergency roof leak, for example. But it can also be a good tool for larger and planned home renovations.

“Home ownership lines of credit are positive when you do, say, a remodel, as you may need different amounts of money throughout the process,” says Hall.

But beware of treating HELOC too much like a credit card, Stratman warns. The money should be used for productive investments that are likely to return more than you pay in interest.

Hall agrees: “I will warn people [against] Use the home’s capital to cover their daily living expenses,” she says.

Second Mortgage vs Refinancing

Home refinancing is another popular way to manage major expenses or support your financial institution. Second mortgages are not the same thing as refinancing. Both can help you provide interest in two different ways.

Refinancing is done when the primary mortgage is restarted – often at a lower interest rate or on better terms. In contrast, you only save interest with a second mortgage via arbitrage, which means you use the money borrowed from the second mortgage to pay off high-interest debt or buy something you were going to use a high-interest credit card for.

Sometimes you have access to cash refinancing, where you can take advantage of new equity in your home and get cash by increasing your mortgage loan to the nearest amount possible.

“If you have an urgent need for money today, cash refinancing can serve a purpose,” says Stratman. Additionally, interest rates on cash refinancing, because it includes a first mortgage, are usually lower than interest rates on a second mortgage.

Refinancing can be more complicated than a second mortgage and usually has more upfront costs.

Here’s how the differences compare:

Pros and Cons of a Second Mortgage

Second mortgages can serve many different purposes, but you should be aware of some risks and shortcomings as well.

Positives

  • 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 achieve more value in the long run

  • HELOCs are flexible, and you only pay for what you use

Negatives

  • Adds to your total debt amount

  • Adds 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 making a cash back on your primary mortgage

When should you consider a second mortgage?

One of the best times to consider getting a second mortgage, says Stratman, is if you’re planning a major home renovation. Putting in a new kitchen or adding a new bedroom, for example, are both investments in your home that are likely to significantly increase its value and are a powerful use of your home ownership.

You can also consider a home purchase line of credit to prepare for unexpected housing costs. In older homes especially, leaky roofs or old heating systems may eventually lead to costly repairs. HELOC insurance may give you a way to pay for it at a much lower interest rate than a credit card or personal loan.

“It really does provide peace of mind,” says Hall.

professional advice

Second mortgages are not only useful for real estate investments – they can also be a great way to consolidate other high-interest debts.

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 works: Let’s say you have a $15,000 credit card balance with an interest rate of 18%. You can pay off the credit card with cash from a second mortgage, which will have a much lower interest rate, and end up saving you money in the long run.

Of course, there are also some scenarios in which you should not use a second mortgage, Stratman and Hall said. If you’re struggling to keep up with your finances because you’re living beyond your means, a second mortgage will only exacerbate the problem and increase your debt burden. Don’t use the money to buy a large lifestyle – for example, a boat or a luxury car – that you wouldn’t be able to afford otherwise.

“The main thing is, if you are getting the money, try to use it as productively as possible without getting the money out of the capital to fund your lifestyle. If it is used responsibly, it can be a good idea,” says Stratman.

About the author

Publishing Team

Leave a Comment