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Second Mortgage, Explained: How It Works, Types, Pros, Cons

By Krystal Etienne · December 19, 2022 · 7 minute read

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Second Mortgage, Explained: How It Works, Types, Pros, Cons

For many homeowners who need cash in short order, a second mortgage in the form of a home equity loan or home equity line of credit is a go-to answer.

What’s the point of a second mortgage? It’s a way to fund everything from home improvements to credit card debt payoff, and for some, a HELOC serves as a security blanket.

You can probably think of many things you could use a home equity loan or HELOC for, especially when the rate and terms may be more attractive than those of a cash-out refinance or personal loan.

Just know that you’ll need to have sufficient equity in your home to pull a second mortgage.

What Is a Second Mortgage?

A second mortgage is one typically taken out after your first mortgage. Less commonly, a first and second mortgage may be taken out at the same time in the form of a “piggyback loan.”

Your house serves as collateral.

An “open end” second mortgage is a revolving line of credit that allows you to withdraw money and pay it back as needed, up to an approved limit, over time.

A “closed end” second mortgage is a loan disbursed in a lump sum.

It’s not called a second mortgage just because you probably took it out in that order. The term also refers to the fact that if you can’t make your mortgage payments and your home is sold as a result, the proceeds will go toward paying off your first mortgage and then toward any second mortgage and other liens (if anything is left).

How Does a Second Mortgage Work?

A home equity line of credit (HELOC) and a home equity loan, the two main types of second mortgages, work differently but have a shared purpose: to allow homeowners to borrow against their home equity without having to refinance their first mortgage.

Rates

HELOCs may have lower starting interest rates than home equity loans, although HELOC rates are usually variable — fluctuating over time.

Home equity loans have fixed interest rates.

In general, the choice between a fixed- vs variable-rate loan has no one universal winner.

Costs

Home equity loans and HELOCs come with closing costs and fees of about 2% to 5% of the loan amount, but if you do your research, you may be able to find a lender that will waive some or all of the closing costs.

Some lenders offer a “no-closing-cost HELOC,” but it will usually come with a higher interest rate.

Example of a Second Mortgage

Let’s say you buy a house for $400,000. You make a 20% down payment of $80,000 and borrow $320,000. Over time you whittle the balance to $250,000.

You apply for a second mortgage. A new appraisal puts the value of the home at $525,000.

The current market value of your home, minus anything owed, is your home equity. In this case, it’s $275,000.

So how much home equity can you tap? Often 85%, although some lenders allow more.

Assuming borrowing 85% of your equity, that could give you a home equity loan or credit line of nearly $234,000.

After closing on your loan, the lender will file a lien against your property. This second mortgage will have separate monthly payments.

Types of Second Mortgages

To qualify for a second mortgage, in addition to seeing if you meet a certain home equity threshold, lenders may review your credit score, credit history, employment history, and debt-to-income ratio when determining your rate and loan amount.

Here are details about the two main forms of a second mortgage.

Home Equity Loan

A home equity loan is issued in a lump sum with a fixed interest rate.

Terms may range from five to 30 years.

Recommended: Exploring the Different Types of Home Equity Loans

Home Equity Line of Credit

A HELOC is a revolving line of credit with a maximum borrowing limit.

You can borrow against the credit limit as many times as you want during the draw period, which is often 10 years. The repayment period is usually 20.

Most HELOCs have a variable interest rate. They typically come with yearly and lifetime rate caps.

Second Mortgage vs Refinance: What’s the Difference?

A mortgage refinance involves taking out a home loan that replaces your existing mortgage. Equity-rich homeowners may choose a cash-out refinance, taking out a mortgage for a larger amount than the existing mortgage and receiving the difference in cash.

Taking on a second mortgage leaves your first mortgage intact. It is a separate loan.

To determine your eligibility for refinancing, lenders look at the loan-to-value ratio, in part. Most lenders favor an LTV of 80% or less. (Current loan balance / current appraised value x 100 = LTV)

Even though the rate for a refinance might be lower than that of a home equity loan or HELOC, refinancing means you’re taking out a new loan, so you face mortgage refinancing costs of 2% to 5% of the new loan amount on average.

Homeowners who secured a low mortgage rate will not benefit from a mortgage refinance when the going rate exceeds theirs.

Pros and Cons of a Second Mortgage

Taking out a second mortgage is a big decision, and it can be helpful to know the advantages and potential downsides before diving in.

Pros of a Second Mortgage

Relatively low interest rate. A second mortgage may come with a lower interest rate than debt not secured by collateral, such as credit cards and personal loans. And when rates are on the rise, a cash-out refinance becomes less appetizing.

Access to money for a big expense. People may take out a second mortgage to get the cash needed to pay for a major expense, from home renovations to medical bills.

Mortgage insurance avoidance via piggyback. A homebuyer may take out a first and second mortgage simultaneously to avoid having to pay private mortgage insurance (PMI).

People generally have to pay PMI when they make a down payment on a conventional loan of less than 20% of the home’s value.

A piggyback loan, or second mortgage, can be issued at the same time as the initial home loan and allow a buyer to meet the 20% threshold and avoid paying PMI.

Cons of a Second Mortgage

Potential closing costs and fees. Closing costs come with a home equity loan or HELOC, but some lenders will reduce or waive them if you meet certain conditions. With a HELOC, for example, some lenders will skip closing costs if you keep the credit line open for three years. It’s a good idea to scrutinize lender offers for fees and penalties and compare the APR vs. interest rate.

Rates. Second mortgages may have higher interest rates than first mortgage loans. And the adjustable interest rate of a HELOC means the rate you start out with can increase — or decrease — over time, making payments unpredictable and possibly difficult to afford.

Risk. If your monthly payments become unaffordable, there’s a lot on the line with a second mortgage: You could lose your home.

Must qualify. Taking out a second mortgage isn’t a breeze just because you already have a mortgage. You’ll probably have to jump through similar qualifying hoops in terms of home appraisal and documentation.

Common Reasons to Get a Second Mortgage

Typical uses of second mortgages include the following:

•   Paying off high-interest credit card debt

•   Financing home improvements

•   Making a down payment on a vacation home or investment property

•   As a security measure in uncertain times

•   For a blow-out wedding (or funeral) with a HELOC chunk

•   College costs

Can you use the proceeds for anything? In general, yes, but each lender gets to set its own guidelines. Some lenders, for example, don’t allow second mortgage funds to be used to start a business.

The Takeaway

What’s the point of a second mortgage? A HELOC or home equity loan can provide qualifying homeowners with cash fairly quickly and at a relatively decent rate.

If you’re looking for a way to put some of your home equity to use, see what SoFi has to offer.

In addition to a cash-out refinance, SoFi offers a brokered home equity line of credit, allowing access to 95%, or $500,000, of your home’s equity.

It’s easy to find your rate.

FAQ

Does a second mortgage hurt your credit?

Shopping for a second mortgage can cause a small dip in a credit score, but the score will probably rebound within a year if you make on-time mortgage payments.

How much can you borrow on a second mortgage?

Most lenders will allow you to take about 85% of your home’s equity in a second mortgage. Some allow more.

How long does it take to get a second mortgage?

Applying for and obtaining a HELOC or home equity loan takes an average of two to six weeks.

What are alternatives to getting a second mortgage?

A personal loan is one alternative to a second mortgage. A cash-out refinance is another.


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