If you’re a homeowner, your house is not only the place you call home but also an asset. In fact, it’s the largest asset of most Americans, according to the most recent Federal Reserve Survey of Consumer Finances.
That asset can be even more valuable, because it can sometimes be used as collateral for a loan, such as a second mortgage.
How Does a Second Mortgage Work?
A second mortgage is an additional loan that you can obtain by using your house as collateral while already holding a mortgage secured by your house. Remember that collateral is something that borrowers own and pledge to give the lender in case they can’t pay back a loan.
An “open end” second mortgage is an open revolving line of credit that allows you to withdraw money and pay it back, as needed, up to a maximum approved limit, over time. A “closed end” second mortgage is a loan disbursed in a lump sum.
It’s not just called a second mortgage because you 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 remaining mortgages (if anything is left) against the home.
Types of Second Mortgages
We just alluded to home equity loans and home equity lines of credit (HELOCs).
Here are details.
Home Equity Loan
Home equity loans are generally limited to 85% of the equity in a home, with the exact amount influenced by income, credit history, and current market value.
You’ll receive a lump sum with a fixed interest rate that will stay the same over the life of the loan. Terms may range from five to 30 years.
Recommended: Exploring the Different Types of Home Equity Loans
Home Equity Line of Credit
As home values spiked, HELOCs became more difficult to get. If you can find one, here’s how they work.
Again, you may be able to borrow up to 85% of the appraised value of your home, less the amount owed on the first mortgage, depending on your creditworthiness.
Because a HELOC is a revolving line of credit rather than a single loan, you can borrow against the credit limit as many times as you want during the draw period, often 10 years.
During the draw period, payments are usually interest-only on the amount withdrawn. After that, you must begin repaying principal and interest on whatever amount you borrowed for the remainder of the term, often 20 years.
Most HELOCs have a variable interest rate that’s tied to the prime rate — an interest rate determined by individual banks — plus a lender’s margin. They typically come with yearly and lifetime interest rate caps.
Recommended: How Do Home Equity Lines of Credit Work?
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. Some borrowers therefore choose to take out a second mortgage to pay off high-interest debt.
PMI avoidance via piggyback. A homebuyer may take out a second mortgage to avoid having to pay private mortgage insurance (PMI). People generally have to pay PMI when they make a down payment of less than 20% of the home’s value.
PMI helps protect the lender if borrowers default on a mortgage. It can add up: Most borrowers pay from $30 to $70 a month in PMI for every $100,000 borrowed, Freddie Mac says.
A “piggyback” second mortgage can be issued at the same time as the initial home loan and allow a buyer to borrow in order to meet the 20% threshold and avoid paying PMI.
Money for a big expense. People may take out a second mortgage to access funds needed to pay for a major expense, from home renovations to medical bills to a wedding.
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 annual percentage rate, or APR, not just interest rate.
Rate issues. Second mortgages generally have higher interest rates than first mortgage loans. And a revolving HELOC “piggyback” second mortgage likely comes with an adjustable interest rate. This 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. If saving for your big expense is an option, that will likely cost you less in the long run than borrowing money.
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 paperwork, home appraisal, and other documentation.
How Does Home Equity Work?
Your home equity is the market value of your home, minus anything still owed.
The more equity you have in your home, the more money that will be available to you should you decide to take out a second mortgage.
There are a few key ways to build equity.
• Pay your mortgage. With each principal payment you make, that much more is added to the overall equity of your home.
• Make home improvements. Installing a new roof or remodeling a kitchen can increase property value. Getting an appraisal after home upgrades can help solidify the increased worth, thus increasing your equity.
• Wait for it to appreciate. Property values are known to rise and fall with the economy. Though inflation may increase the overall equity of a home, its worth is more closely tied to the supply and demand of the real estate market. For instance, during times of high demand but a low supply of homes, home values are known to increase.
Second Mortgage vs. Refinance: What’s the Difference?
Refinancing your home loan also involves taking out a loan, but in this case the new loan replaces your existing mortgage.
People choose a traditional refinance to gain a lower interest rate, a lower monthly payment, a different loan term, or a fixed rate instead of an adjustable one.
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.
Lenders look at your loan-to-value ratio, in part, to determine your eligibility for refinancing. (To find your LTV ratio, divide how much you owe on your current mortgage by the current value of the property and multiply by 100.) Once you know your LTV ratio, you can think about the loan amount you want to apply for. Just realize that most lenders favor an LTV of 80% or less.
Two cons of refinancing:
• Since refinancing means you’re taking out a new loan, you face closing costs.
• Just like a second mortgage, a refinanced mortgage uses your home as collateral, so the lender can seize your property if you fail to pay.
The main pros of refinancing:
• Record-low rates could mean monthly savings.
• A lower rate or shorter term could translate to significantly less interest paid over the life of the loan.
• The rate for a cash-out refinance is typically lower than that of a home equity loan or HELOC.
There’s a lot to think about for homeowners pondering a second mortgage or a refi. You may want to ask yourself:
• How much equity do I have in my home?
• How much do I want to borrow?
• When do I hope to repay the loan?
• What’s my current mortgage rate?
• Do I really want a fixed rate or is a variable rate OK?
• Is adding debt with a second mortgage fine, or is refinancing my original mortgage the way to go?
A second mortgage — a HELOC or home equity loan — can be advantageous for homeowners. So can a refinance or cash-out refi. It’s all about weighing your individual goals and needs.
If a new mortgage, refinance, or cash-out refinance sound appealing, SoFi offers all of them at competitive rates.
If a home equity loan is a better fit, SoFi has teamed up with Spring EQ on tapping home equity.
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