2020 was a financially sound year for homeowners since the home equity has an average gain of $26,300 last year. According to Corelogic, an average homeowner has more than $200,000 in equity.
The pandemic brings in unprecedented financial difficulties, during which time you may need access to a large amount of money. Consider tapping into the equity and take out a second mortgage.
This article walks you through the inside workings of second mortgages, closing costs, interest rates, pros and cons, qualifications, requirements, the application process, and much more.
How Does a Second Mortgage Work?
The second mortgage is a loan similar to the one used to purchase your home. The reason it’s called a 2nd mortgage is that it is next in line to be repaid after your purchase loan.
Since it uses your home as collateral, the second mortgage lender can repossess your home if you fail to repay. In that case, the loan used to purchase your home is the first one to be repaid. The remaining, if any, will go towards the second mortgage.
Second mortgages tap into your home’s equity, which is the current market value of your home minus the loan balance. In most cases, lenders would let you borrow 85% of the home equity, depending on your credit score.
And, since the second mortgage loan is taken against your home, it has a lesser interest rate than other loans such as personal loans or credit cards. Depending on your choice of loan, it can either be a fixed rate or variable rate.
Types of Second Mortgages
The common types of second mortgages are:
- Home Loans: The lender gives you a lump sum where you get the entirety of the loan amount to use as you wish. The loan is then repaid in fixed monthly payments. Generally, they come with a fixed interest rate and a fixed term.
- Equity Lines of Credit: The lender gives you a line of credit from where you draw a certain amount of money as and when you wish, just like a credit card. Line of credit usually comes with adjustable rates.
Since they are secured against your home, they are cheaper than most loans but not as much as the first mortgage.
Is a 2nd Mortgage a Good Idea?
Second mortgages can be a great source of money when you require a lump sum at a reasonable rate of interest. They are a good idea when used for things that have long-term value.
Most people take out a second mortgage for things that have a long-term value, such as:
- Home Improvements – You can proceed with home improvements such as a kitchen remodel or bathroom renovation, etc.
- Debt Consolidation – The loan gives you the chance to pay off high-interest loans such as student loans, credit cards, etc.
However, it is not advisable to use it for inconsequential things that do not add value.
Closing Costs on Second Mortgages
As with the primary mortgage, the second mortgage also has closing costs, though reasonably reduced. Even then, it amounts to 5-6% of the loan amount.
For loans up to $200,000, the lenders charge a “flag” title insurance policy with a flat fee of $125 and a sub-escrow fee which is $225 -$250.
Additionally, the standard fees such as the recording fees, notary fees, and the payoff fees amount to $60-$150. And then, there are the administrative fees charged by the lenders that come to $250.
Apart from that, you may have to pay an additional cost of $300 – $400 if an appraisal is required. Finally, the credit fees come to $15 – $30.
How Much Home Equity Do You Need for a Second Mortgage?
Though equity requirements vary, second mortgage lenders prefer that you have a 15% – 20% equity in your home.
You can borrow up to 85% of the home’s equity, which is 85% of your home’s value – any loan balances. For example, consider your home’s worth to be $300,000 and loan balance $200,000.
85% of $300,000 = $240,000.
2nd mortgage would be $240,000 – $200,000 = $40,000.
Does a Second Mortgage Have Any Tax Benefits?
The tax benefits primarily depend on the kind of debt.
When your second mortgage is used to buy, build or improve a primary/second home, it becomes a home acquisition loan. If the home acquisition debt and the home equity debt combined together come up to $1.1 million, you could deduct all your interest in that particular year.
However, if the home acquisition loan is $2,000,000, you’ll be able to deduct only half of the total interest paid that year.
Can You Get a Second Mortgage to Buy Another House?
Yes! You can use a second mortgage to buy another house. Tapping into the home equity allows you to enjoy better rates of interest and tap into the financial resources that lay untouched otherwise.
If your second home is an investment property, home equity is often the least expensive option since they have lower interest rates.
Are Second Mortgage Rates Higher than First Mortgage Rates?
Second mortgages have higher interest rates than the first mortgage. This poses a risk to the lenders since they are second-in-line to be paid in case of foreclosure.
However, a second mortgage has lower interest rates than other unsecured loans such as personal loans and credit cards.
How Much Does It Cost to Get a Second Mortgage?
Second mortgages cost 2%-5% of the mortgage amount both in upfront costs and those that are paid over a period of time. Most of these are similar to that of the primary mortgage but are paid separately since they are considered to be separate loans.
Pros and Cons of Second Mortgages
Second mortgages, as with every other loan, come with their own pros and cons. Talk with your lender and consider the risks to make sure the second mortgage loan is the right one for you.
Pros of a Second Mortgage
Lump-Sum: Second mortgages allow you to borrow a significant amount of money. Since the loan is secured by your home, you would be able to borrow much more than unsecured loans.
Lower Interest Rate: Second mortgages have lower interest rates than other loans since they use real estate as collateral which reduces the risk to the lender.
Tax Benefits: In certain cases, the interest accrued will be eligible for tax benefits. According to the Tax Cuts and Jobs Act, you’ll be able to claim deductions if used for home improvements.
No Limits: Second mortgages give you the freedom to use the mortgage amount as you wish. You can use it for big purchases you wouldn’t be able to afford otherwise.
Cons of a Second Mortgage
Risk of Foreclosure: Since the loan uses your home as collateral, you run the risk of foreclosure if you fail to pay it back.
Closing Costs: Second mortgages can be expensive, much like your primary mortgage. The closing costs can end up in thousands of dollars in origination fees, appraisals, credit checks, and more.
Interest Rate: Though the rate of interest is much lesser than your credit card, it is higher than your purchase loan.
Undue Pressure on Your Budget: A second mortgage adds to your debt burden even with your low-interest rate. It can place pressure on your budget, especially if you are living paycheck to paycheck.
Requirements for Second Mortgage
To qualify for a second mortgage in the form of a home equity loan or HELOC, you’ll need:
- A credit score of 620
- A debt-to-income ratio of 43%
- A decent amount of equity
Below is the paperwork your lender will require before closing the loan:
- Copy of the deed to the property
- Tax appraisal
- W-2 (last 2 years)
- Tax returns (last 2 years)
- Paystub (current)
- Proof of income (child alimony, disability payments, child support, lawsuit settlement, inheritance, and other sources of income)
- Copies of bank statements (3-6 months)
- Open credit accounts
- Current loan statement
- Homeowners insurance
Apply for a Second Mortgage
In terms of getting a second mortgage, the application process is similar to a primary mortgage; you do not need any home appraisal or inspection. However, you may need an assessment to determine the current value of your home.
To start with, talk with your lender to check if you are eligible for other financing options, including refinancing.
Here’s the application process for the second mortgage.
- Calculate the equity in your home and how much you can borrow.
- Gather all the required documentation, preferably in digital format, to speed up the timeline.
- Shop around different lenders for better rates. Compare the lenders and financing options for your situation.
- Once you finalize the lender, make sure you fill out the application with the correct details, or it may delay the approval.
- Fax or email the documentation to save time and expedite the process.
- Letting the lender know the reason for the loan may help with the approval process.
- Your lender may want to conduct an appraisal and inspection if it hasn’t been done in the last six months.
- Review the disclosure documents and verify the payment terms.
- Ensure that the terms of the loan match with what you have agreed to.
Piggyback loans — also known as 80-10-10 loans — are an entirely different kind of second mortgage. Rather than borrowing against your home equity, you get a loan piggybacking the primary mortgage. In short, you’d be using two mortgages to purchase your home. The first mortgage typically covers 80% of the home price, and the second mortgage covers 10%. The remaining 10% is covered by your down payment.
It is generally used to cover parts of the down payment and avoid private mortgage insurance (PMI), as well as avoid taking a jumbo loan where the interest rates are significantly higher.
First Mortgage vs. Second Mortgage
Similar to a first mortgage, a second mortgage is also taken with your home as collateral.
The first mortgage is the primary loan that you take to purchase your home. The interest rates are significantly lower than many other loans. Additionally, they are also tax-deductible. However, the closing costs may be high and needs to be paid upfront.
The drawback is that you do not possess the ownership of the property until you pay back the loan. And defaulting on the monthly payment can lead to foreclosure, with the primary mortgage being paid first.
On the other hand, the second mortgage is taken on the home equity in addition to the primary mortgage. The rate of interest is high when compared to first but lower than the unsecured loans.
Second Mortgage vs. Home Equity Loan
Home equity loans are pretty similar to second mortgages that many confuse between the two. They are alike in every aspect, including that they use home equity to finance the loans. You’ll need to retain 20% home equity to qualify for both these loans.
The rate of interest is fixed so are the payment terms. You make a monthly payment, failing which you will face foreclosure. A home equity loan is available in a lump sum similar to the second mortgage.
Second Mortgage vs. Home Equity Line of Credit
A home equity line of credit (HELOC) is also quite similar to a second mortgage in that it is financed by home equity. It has a revolving credit line from where you can borrow money and then make monthly payments, just like your credit card.
A HELOC also has a draw period, say ten years, where you can borrow money. After the draw period comes the repayment period, during which time you have to pay it off. Once you have paid it back, you can use the money on your credit line repeatedly without applying for more home equity lines of credit.
Like the second mortgage and the home equity loan, your home is at risk of foreclosure if you miss monthly payments.
By taking out a second mortgage, you tap into the home equity to finance your home improvements, big purchases, and such. While it has its risks, the lower interest is an attraction.
You can use a second mortgage to make substantial improvements to your home, settle debts on loans that carry a higher interest rate. Like the purchase loan, it is taken against the real estate, which means that the first mortgages have priority when the borrower defaults.
You need not take out a second mortgage from the same lender as your primary loan. Shop around and find the lender who carries the best rates. Also, look around for other loans appropriate for your financial situation.
Priority Lending, LLC has been providing mortgage loans and helping people like you fulfill their dreams since 1997. Contact one of our loan officers today to get started on refinancing your mortgage.