The Cobb Group Blog

We’ve heard the chatter lately from friends and neighbors who are thinking about taking out a second mortgage. If it’s pertinent to them, it may be on your mind too. Don’t get confused, research and ask for help. Here are some facts to see if it is right for you.

A second mortgage is a type of loan that lets you borrow against the value of your home. Your home is an asset, and over time, that asset can gain value. Second mortgages, which can be home equity lines of credit (HELOCs) or home equity loans, are a way to use that asset for other projects and goals without having to sell your home.

What Is a Second Mortgage? 

A second mortgage is a loan that uses your home as collateral, similar to the loan you used to purchase your home. The loan is known as a second mortgage because your purchase loan is typically the first loan in line to be repaid if your home goes into foreclosure.

This means that if a worst-case scenario occurs and you can no longer pay your mortgage and the lender sells your home, your first mortgage would be paid first. Your second mortgage would receive any remaining funds after the first mortgage is paid.

Second mortgages tap into the equity in your home, which is the market value of your home less any loan balances. Equity can increase or decrease, but ideally, it grows over time. Equity can change in a variety of ways:

• When you make monthly payments on your loan, you reduce your loan balance, increasing your equity.

• If your home gains value because of a strong real estate market or improvements you make to your home, your equity increases.

• You lose equity when your home loses value or you borrow against your home.

Second mortgages can come in several different forms.

• A lump sum: A standard second mortgage is a one-time home equity loan that provides a lump sum of money you can use for whatever you want. With that type of loan, you’ll repay the loan gradually over time, often with fixed monthly payments. With each payment, you pay a portion of the interest costs and a portion of your loan balance in a process called amortization.

• A line of credit: It’s also possible to borrow using a line of credit, or a pool of money that you can draw from. With that type of loan, you’re never required to take any money—but you have the option to do so if you want to. Your lender sets a maximum borrowing limit, and you can continue borrowing (multiple times) until you reach that maximum limit. As with a credit card, you can repay and borrow over and over.

Depending on the type of loan you use and your preferences, your loan might come with a fixed interest rate that helps you plan your payments for years to come. Variable-rate loans are also available and are the norm for lines of credit.

Advantages of Second Mortgages 

Why take out a second mortgage? Here are a few reasons to consider one.

Loan Amount 

Second mortgages allow you to borrow significant amounts. Because the loan is secured by your home (which is usually worth a lot of money), you have access to more than you could get without using your home as collateral. How much can you borrow? It depends on your lender, but you might be able to borrow up to 85% of your home’s value. That maximum would count all of your home loans, including first and second mortgages.

Interest Rates  

Second mortgages often have lower interest rates than other types of debt. Again, securing the loan with your home helps you because it reduces the risk for your lender. Because the loans are lower risk, lenders offer lower rates on second mortgages than unsecured personal loans like credit cards.

Tax Benefits 

In some cases, you’ll be able to take a mortgage interest deduction for interest paid on a second mortgage. There are numerous technicalities to be aware of, so ask your tax preparer before you start taking deductions. For tax years after 2017, the Tax Cuts and Jobs Act eliminates the deduction unless you use the money for "substantial improvements" to a home.

Disadvantages of Second Mortgages 

Benefits always come with tradeoffs. The costs and risks mean that these loans should be used wisely.

Risk of Foreclosure 

One of the biggest problems with a second mortgage is that you have to put your home on the line. If you stop making payments, your lender will be able to take your home through foreclosure, which can cause serious problems for you and your family. For that reason, it rarely makes sense to use a second mortgage for “current consumption” costs. For entertainment and regular living expenses, it’s just not sustainable or worth the risk to use a home equity loan or line of credit.

Loan Costs 

Second mortgages, like your purchase loan, can be expensive. You’ll need to pay numerous costs for things like credit checks, appraisals, origination fees, and more. Closing costs can easily add up to thousands of dollars. Even if you’re promised a "no closing cost" loan, you’re still paying—you just don’t see those costs transparently.

Interest Costs 

Any time you borrow, you’re paying interest. Second mortgage rates are typically lower than credit card interest rates, but they’re often slightly higher than your first loan’s rate.

Second mortgage lenders take more risk than the lender who made your first loan.

WARNING: If you stop making payments, the second mortgage lender won’t get paid unless and until the primary lender gets all of its money back.

Common Uses of Second Mortgages 

Consider how you plan to use the funds from your loan. It’s best to put that money toward something that will improve your net worth (or your home’s value) in the future. This is because you’ll need to repay these loans, they’re risky, and they cost a lot of money. Here are a few common ways to use a second mortgage.

• Home improvements: Renovations are a common use for second mortgage funds because the assumption is that you’ll repay the loan when you sell your home with a higher sales price.

• Avoiding private mortgage insurance (PMI): It might be possible to avoid PMI with a combination of loans. For example, an 80/10/10 strategy or “piggyback” loan uses a second mortgage to keep your primary mortgage's loan-to-value ratio at or below 80%. Just make sure it makes sense compared to paying—and then canceling—PMI.

• Debt consolidation: You can often get a lower rate with a second mortgage, but you might be switching from unsecured loans to a loan that could cost you your house.

• Education: You may be able to set yourself up for a higher income. But as with other situations, you’re creating a situation where you could face foreclosure. Standard student loans might be a better option.

WARNING: Beware of risky loan features like balloon payments and prepayment penalties.

Tips for Getting a Second Mortgage 

Shop around and get quotes from at least three different sources. Be sure to include the following in your search:

1. A local bank or credit union

2. A mortgage broker or loan originator (ask your real estate agent for suggestions)

3. An online lender

Get prepared for the process by getting your documents ready. This will make the process much easier and less stressful.

BY Justin Pritchard l Updated April 13, 2020 for thebalance.com