Second Mortgage: What It Is, How It Works, Lender Requirements

What Is a Second Mortgage?

A second mortgage is a type of subordinate mortgage made while an original mortgage is still in effect. In the event of default, the original mortgage would receive all proceeds from the property’s liquidation until it is all paid off.

Since the second mortgage would receive repayments only when the first mortgage has been paid off, the interest rate charged for the second mortgage tends to be higher, and the amount borrowed will be lower than that of the first mortgage.

How a Second Mortgage Works

When most people purchase a home or property, they take out a home loan from a lending institution that uses the property as collateral. This home loan is called a mortgage, or more specifically, a first mortgage. The borrower must repay the loan in monthly installments made up of a portion of the principal amount and interest payments. Over time, as the homeowner makes good on their monthly payments, the home also tends to appreciate in value.

The difference between the home’s current market value and any remaining mortgage payments is called home equity. A homeowner may decide to borrow against their home equity to fund other projects or expenditures. The loan they take out against their home equity is a second mortgage, as they already have an outstanding first mortgage. The second mortgage is a lump-sum payment made out to the borrower at the beginning of the loan.

Like first mortgages, second mortgages must be repaid over a specified term at a fixed or variable interest rate, depending on the loan agreement signed with the lender. The loan must be paid off first before the borrower can take on another mortgage against their home equity.

Using a mortgage calculator is a good resource to budget these costs.

Using a HELOC as a Second Mortgage

Some borrowers use a home equity line of credit (HELOC) as a second mortgage. A HELOC is a revolving line of credit that is guaranteed by the equity in the home. The HELOC account is structured like a credit card account in that you can only borrow up to a predetermined amount and make monthly payments on the account, depending on how much you currently owe on the loan.

As the balance of the loan increases, so will the payments. However, the interest rates on a HELOC and second mortgages, in general, are lower than interest rates on credit cards and unsecured debt. Since the first or purchase mortgage is used as a loan for buying the property, many people use second mortgages as loans for large expenditures that may be very difficult to finance. For example, people may take on a second mortgage to fund a child’s college education or purchase a new vehicle.

Requirements for a Second Mortgage

To qualify for a second mortgage, you will need to meet a few financial requirements. You typically will need a credit score of 620 or higher, a debt-to-income (DTI) ratio of 43% or lower, and a decent amount of equity in your first home. Because you are using the equity in your home for the second mortgage, you will need to have enough to not only take out your second loan but also to be able to keep approximately 20% of your home’s equity in the first mortgage.

Special Considerations

Borrowing Limits

It may be possible to borrow a hefty amount of money with a second mortgage. Second mortgage loans use your home (presumably a significant asset) as collateral, so the more equity you have in a home, the better. Most lenders will allow you to borrow at least up to 80% of your home’s value, and some lenders will let you borrow more.

Approval Time

Like all mortgages, there is a process for obtaining a HELOC or a home equity loan, and the timeline may vary. You will need to apply for an appraisal of your home, and it usually takes the lender’s underwriter a few weeks to review your application. It could be four weeks, or it could be longer, depending on your circumstances.

Second Mortgage Costs

Just like the purchase mortgage, there are costs associated with taking out a second mortgage. These costs include appraisal fees, costs to run a credit check, and origination fees.

Although most second-mortgage lenders state that they don’t charge closing costs, the borrower still must pay closing costs in some way—the cost is included in the total price of taking out a second loan on a home.

Since a lender in a second position takes on more risk than one in the first position, not all lenders offer a second mortgage. Those that do offer them take great steps to ensure that the borrower is good to make payments on the loan. When considering a borrower’s application for a home equity loan, the lender will check whether the property has significant equity in the first mortgage, a high credit score, stable employment history, and a low debt-to-income ratio.

Advantages and Disadvantages of a Second Mortgage

Taking out a second mortgage means you can access a large amount of cash using your home as collateral. These loans often come with low interest rates, plus a tax benefit. You can use a second mortgage to finance home improvements, pay for higher education costs, or consolidate debt.

However, there are risks when taking out a second mortgage, and they can be substantial. Notably, you run the risk of losing your home if you can’t make payments. Expect to pay closing costs, appraisal fees, and credit checks during the process.

Second Mortgages vs. Home Equity Loans

Home equity loans are another term for a second mortgage. As opposed to a home equity line of credit, which has a revolving credit limit, home equity loans are paid out in lump sums with fixed repayment terms. Both products use the original property as collateral to make it a secured loan and come in secondary priority to the primary mortgage in the event of a foreclosure.

The Bottom Line

If you qualify for a second mortgage, it can help you pay for home improvements and major renovations, make a down payment on a second home, or pay for your child’s college. Second mortgages can also be a method to consolidate debt by using the money from them to pay off other sources of outstanding debt, which may carry even higher interest rates.

Because the second mortgage also uses the same property for collateral as the first mortgage, the original mortgage has priority on the collateral should the borrower default on their payments. If the loan goes into default, the first mortgage lender gets paid before the second mortgage lender. This means that second mortgages are riskier for lenders, which is why they ask for a higher interest rate on these mortgages than on the original mortgage.

You don’t necessarily have to take out a second mortgage from your first mortgage lender. When you are shopping around for a second mortgage, it is advisable to get rate quotes from a variety of sources, including banks, credit unions, and online mortgage lenders.