What Is a Second Mortgage and How Does It Work? (2024)

How Does a Second Mortgage Work?

Your original mortgage covered the purchase of your home. A second mortgage allows you to borrow again, accessing the equity you’ve accrued in the property over time. It’s a separate loan, with its own interest rate, term and repayment schedule.

The amount you can borrow is based on your home equity. You build equity in your home by paying down the balance owed on your original mortgage – and appreciation in your home’s value.

Just like a first mortgage, a second mortgage uses your home as collateral. This means your lender may have the right to foreclose on your home if you fail to make your payments. But the security this offers may allow you to borrow more and at better rates.

A second mortgage usually has a higher interest rate than your original mortgage because, in the case of a default, the primary mortgage will be satisfied first.

Types of Second Mortgages

Two primary types of second mortgages are commonly known as home equity loans and home equity lines of credit (HELOCs).

Home Equity Loan

A home equity loan is borrowed as a lump sum that is paid back at a fixed interest rate over a set period of time. Most lenders like to leave 20% equity in the home.

You don’t have to borrow the full amount available, and it’s prudent to not borrow more than you need. Typically, the loan terms come with a fixed interest rate and monthly repayments. Payments begin shortly after closing on the loan.

Home Equity Line of Credit (HELOC)

A HELOC is a revolving line of credit — similar to a credit card — that is based on the available equity in your home. You can borrow from your credit as much as you want during the active draw period. Draw periods vary in length but can sometimes be 10 years or more. During that time, you make interest-only payments.

Usually, the interest rates on HELOCs are variable. You only pay interest on the amount that you actually borrow — not the entire line of credit available. After the draw period ends, you enter the repayment phase, where you must begin to pay down the entire balance.

>> Related: Read more about HELOCs vs. Home Equity Loans

Benefits of Getting a Second Mortgage

The best second mortgages can be an attractive option for homeowners who are sitting on a large amount of equity but don’t want to refinance. A second mortgage gets you a lump sum of money without altering your original mortgage terms, which can be helpful if rates have risen since you first took out your mortgage.

Second mortgages often offer lower interest rates than other financing options like personal loans or credit cards thanks to being secured by collateral.

Lenders are taking on less risk by using your home to secure the loan, and in return, you benefit from a lower interest rate.

Another potential benefit is your mortgage interest may be tax deductible depending on what you use the money for. If you use your loan for home renovations, you may be in line for a tax break.

Drawbacks of Getting a Second Mortgage

Second mortgages can be a great tool, but they come with some risks you need to consider.

First, these types of loans typically come with origination fees and closing costs, adding to your debt amount.

Because the real estate market is volatile, it’s also possible you could end up with an upside-down mortgage — a situation where the total amount on your mortgage(s) is more than your home is worth. As such, if you decide to sell your home while still owing on both mortgages, the sale price needs to satisfy both loans. This could leave you with little equity left to purchase a new home after the sale.

Second Mortgage vs. Refinance

A second mortgage and a mortgage cash-out refinance both allow you to access your home’s equity, but they operate differently.

A cash-out refinance involves paying off your original mortgage and replacing it with a new loan for a higher amount, with the difference coming to you as cash. This is common when interest rates have dropped and you’re able to secure a new loan at a more favorable rate. It can also be a cost-effective strategy to consolidate debt if you qualify for a new, lower rate.

A second mortgage leaves your first mortgage as is and adds another loan on top. This approach can be preferable if you wish to retain the terms of your initial mortgage, but still want to access the equity in your home for renovations, debt consolidation or other major purchases.

Alternatives to a Second Mortgage

If you need funds for expenses such as home upgrades, debt consolidation and higher education expenses, there are alternatives to home equity loans and HELOCs. Here are some options to consider:

Qualifying for a Second Mortgage

To qualify you for a loan, lenders want to know you have sufficient equity in your home and the ability to repay both the first and second mortgages. They will look at your income, creditworthiness and overall debts.

Typically, lenders look for a minimum credit score at or above 620 – which is generally considered “fair” credit, according to credit scoring company FICO. Credit scores are a numerical gauge of how likely you are to repay a loan. The better your credit score, the better interest rate you can get. They also want a reasonable debt-to-income ratio, which measures your monthly earnings to your overall existing loans. Usually, lenders want to see a ratio that’s less than 43% of your income.

Having a combined loan-to-value ratio of under 80% is also important — this means that your original mortgage is less than 80% of the appraised value of your home.

How to Get a Second Mortgage

Once you have decided to get a second mortgage, here’s how to go about obtaining one:

• Shop around: If you are a qualified borrower, research rates and terms from various lenders. They may offer special rates or promotions that you can benefit from.

• Get prequalified: Getting prequalified will offer you an idea of your potential rates and repayment terms without a hard pull on your credit.

• Gather documentation: Pull together all your personal documents like pay stubs, tax returns, etc.

• Fill out an application: Complete the loan application accurately and completely. Then, it will go through the underwriting department for verification.

• Get an appraisal: Your lender will request an appraisal to determine your home’s value and available equity.

• Get approved: Approval from your lender can take anywhere between two weeks and two months. Your loan officer should be in contact throughout the process.

• Close and fund: Once approved, your lender will set a closing date. There you will sign the paperwork for the new loan and receive your funds within a few business days.

The Bottom Line

A second mortgage can be a valuable way to access the stored equity in your home, without losing your original mortgage terms. They offer lower interest rates than other types of loans but come with the risk of using your home as collateral.

There are alternatives to second mortgages, but they may not offer the same benefits such as tax deductions. If you are a qualified borrower, compare multiple lenders and get prequalified to guarantee the best rates and terms for your second mortgage.