A second mortgage is a type of loan that lets you tap into the equity of your home. If you’ve paid off a portion of your first mortgage or your home has gained value, you have the opportunity to put the money you have in your home to good use.
When you get a first mortgage, you use the money to buy a home. A second mortgage gives you cash to cover other expenses. Both mortgages use your home as collateral, so if you fail to make payments, your home is foreclosed upon to pay off your mortgages.
You’ll still keep your first mortgage. You’ll get a second mortgage on top of your initial one, and you’ll have two mortgage payments each month.
Taking out a second mortgage is one way to access a large sum of money, and you may find you prefer it to taking out a personal loan or using a credit card.
Home equity is the amount of your home that you own. When you take out a mortgage, you don’t own the house outright. The more you pay down your loan, the more of your home you own, financially speaking.
For example, let’s say you buy a $200,000 home. You have $20,000 for a down payment, so you take out a $180,000 mortgage. Divide $20,000 by $200,000 to get 0.10 — you have 10% equity in your home from the get-go.
Fast forward a few years, and you’ve paid off another $40,000 of your mortgage principal. (Payments toward your interest don’t help you build equity.) You’ve now paid $60,000 toward your $200,000 house, so you have 30% equity in your home.
Making payments toward your mortgage is the simplest way to gain equity. Your home may also gain value if the local housing market improves or you make home improvements. Or you could lose equity if the home value drops.
The amount of equity you have affects how much you can borrow with your second mortgage. Rules vary by lender, but many companies want you to keep at least 20% equity in your home after taking out the second mortgage. So if you have 30% equity in your home, you can borrow the equivalent of 10% of your equity.
There are two types of second mortgages: home equity loans and home equity lines of credit.
Home equity loan
With a home equity loan, you receive cash in one lump sum. Then you pay it back in monthly installments over a predetermined amount of time, like 30 years. It’s a similar concept as a regular mortgage, except it provides you with cash.
Home equity line of credit
A HELOC works more like a credit card than like a regular mortgage. The lender gives you a borrowing limit, and you can borrow from that line of credit as needed. Maybe you take out $5,000 to pay off a credit card, then $10,000 later to remodel your bathroom.
As with a credit card, you’ll pay back what you borrow, and you can borrow more later. If your borrowing limit is $20,000 and you borrow $10,000, you have $10,000 left to borrow. But if you pay back the full $10,000, your limit is back to $20,000.
Your lender gives you a “draw period,” which is a chunk of time you’re allowed to borrow money — usually 10 years or less. At the end of the draw period, you must repay any balance you haven’t paid back yet.
A second mortgage isn’t the same thing as a refinanced mortgage. When you take out a second mortgage, you tack another mortgage onto your initial one. When you refinance, you replace your first mortgage with a brand-new one that has different terms.
With a second mortgage, you make two mortgage payments each month, one toward the first and one toward the second. With a refinanced mortgage, you just make one monthly mortgage payment.
Second mortgage interest rates are usually higher than refinance rates, because second mortgages are riskier for lenders. If you were to foreclose on your home, the funds would pay off the original mortgage first, then the second. It’s possible the second mortgage wouldn’t be paid off in full with a foreclosure. When loans are riskier for lenders, they usually charge higher rates.
There is a type of mortgage refinance that’s very similar to a home equity loan: a cash-out refinance. With a cash-out refinance, you borrow against the equity you have in the home and receive cash.
The main difference between a second mortgage and a cash-out refinance is that the latter replaces your first mortgage all together. Cash-out refinances usually charge lower rates than home equity loans or HELOCs, but closing costs are more expensive.
Just as with your first mortgage, you’ll need to meet specific requirements to qualify for a second mortgage. Here are the terms you can expect:
- Home equity. You need to have equity in your home to qualify for a second mortgage. Many lenders want you to keep 10% or 20% of your equity after closing on a second mortgage, so take that into consideration before applying.
- Credit score. Each lender is different, but you’ll probably need at least a 620 credit score. To improve your credit score before applying for a second mortgage, make sure you’re paying all your bills on time. You can also let your credit age and pay down debts.
- Debt-to-income ratio. Your DTI ratio is the amount you pay toward debts each month, divided by your gross monthly income. Lenders usually want to see a DTI ratio of 43% or less for a second mortgage, but again, it depends on the lender. Look into paying down some debts to lower your ratio, or think about any opportunities to earn more money.
If you qualify for a second mortgage, the next step is to determine whether applying for one is the best choice for you.
Like any big purchase, a second mortgage has its pros and cons. Here are some factors to consider:
- Relatively low interest rate. A second mortgage charges a lower rate than a credit card. Depending on various factors, a second mortgage could have a lower rate than a personal loan, too.
- Borrowing limit. You may be able to borrow more with a second mortgage than with a credit card. Your mortgage borrowing limit will depend on how much equity you have in your home, though.
- Money for other expenses. There are no rules surrounding how you can or can’t spend the cash you receive from a second mortgage. You may decide to spend it making major home improvements or enrolling in school. It’s probably not a good idea to take out a second mortgage to cover frivolous expenses, though, because you will pay closing costs and interest. But ultimately, it’s up to you whether a purchase is worth taking out a second mortgage.
- Closing costs. Yes, you’ll pay closing costs on a second mortgage. But they’re usually cheaper than cash-out refinance closing costs.
- Rate. Although a second mortgage rate is lower than a credit card rate, it’s higher than what you’ll pay on some other types of loans. Be prepared to pay a higher interest rate on a second mortgage than your initial mortgage. Second mortgages are riskier for lenders, so they charge steeper rates. You’d also pay a lower rate on a regular refinance or cash-out refinance.
- Budget. You’ll make two separate mortgage payments per month: one toward your initial mortgage, one toward your second. Think about your monthly budget and whether adding another debt payment would be too much of a strain.
- Closing costs. When you get a second mortgage, you’ll pay closing costs all over again, which will likely add up to thousands of dollars.
A second mortgage can be a good tool for covering big expenses, especially if you’ve gained a good chunk of equity in your home. Just make sure it’s the right financial move for your situation.
Laura Grace Tarpley is the associate editor of banking and mortgages at Personal Finance Insider, covering mortgages, refinancing, bank accounts, and bank reviews. Over her four years of covering personal finance, she has written extensively about ways to save, invest, and navigate loans.