You'll often hear the term "second mortgage" come up when watching a movie or TV show when a character isn't in a great financial standing. "They had to take out a second mortgage on their house," a gossipy character will whisper, describing how their frenemy has fallen on bad times. But second mortgages get a bad rap—though risky, they're often a great tool to solve financial problems or even wisely get ahead.
Second mortgage definition:
Before we delve into the nitty gritty of a second mortgage, let's get on the same page with what exactly it is. Your first mortgage is a loan that helps finance the purchase of a home so you don't have to put up hundreds of thousands of dollars all at once (because let's be real: Who has that kind of money?)
But a second mortgage essentially allows you to borrow money from your home's equity. Equity is the non-financed portion of your home's value, so essentially you are making the money you've paid into your home usable for other things. "Let's say your house is worth $250,000 today, and you owe $150,000," says Holden Lewis, NerdWallet's mortgage specialist. "Subtract the debt from the home value and that's your equity: $100,000." Your home's equity can grow and shrink outside of your mortgage payment: Value gained from a strong real estate market or improvements you've made can translate into increased equity. That said, you can also lose equity if your home depreciates in value or the housing market crashes.
However, you can't always just take out all of your equity in your home: "Most home equity lenders want to hold the total debt (for both mortgages) to 80 percent of the home's value, or sometimes 90 percent," Explains Lewis, "So in [this] example, the home is worth $250,000, and 80 percent of that is $200,000. If you owe $150,000 on the primary mortgage, then that gives you up to $50,000 you can borrow."
Just like your first mortgage, your home is held as collateral for your second mortgage. If you default on your mortgage, the bank has the authority to take your home as repayment.
Why take out a second mortgage:
Okay, now that you understand what a second mortgage actually is, let's delve into why you would want one. In some cases, you might have aggressively paid down your mortgage to save on interest payments, and want to free up some funds to use in case of emergency. You also might want to do a large renovation to increase your equity but, again, don't have the cash on hand to afford it. In some situations, it might also make sense to use your home equity to consolidate debts (a.k.a. pay off multiple debts with high interest rates with one big loan with a smaller interest rate), pay for education, or even large medical bills. For others, adding a second mortgage is the best way to afford a home without a 20 percent down payment.
Types of second mortgages:
Now, if it wasn't confusing enough that there are first and second mortgages, there are actually two predominant types of second mortgages: A home equity loan and a home equity line of credit (HELOC). Let's talk about the differences:
Home equity loan:
A home equity loan is a one-time 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. Home equity loans typically have a fixed interest rate and loan term, and you pay the same amount monthly. Essentially, they work exactly like your first mortgage, however they usually come with a higher interest rate than your first mortgage since you are adding a bit more risk to your home financing, Patrick Boyaggi, CEO of rategravity.com, says.
Home equity line of credit:
A home equity line of credit (HELOC) is, well, your home's equity turned into a line of credit. Whoever your lender is will set a maximum borrowing limit, and you can borrow however much at any point until you've reached the maximum. You also can have a HELOC and never use it, but it's there if you need it. This is why lines of credit are often compared to credit cards—and they typically have lower interest rates than your plastic does. They also don't amortize, like a home equity loan. However, HELOCs come with adjustable rates, so monthly payments can rise or fall, depending on federal reserve rates.
Now that you understand what a HELOC is, here's a doozy: If you're super close to paying off your mortgage and want to deduct more interest (if you remember, since mortgages are amortized, you're paying more interest up front in your 30-years) you can take out a second mortgage in the form of a HELOC, pay off your mortgage, and then use your HELOC as your first mortgage and deduct THAT interest. (If you're confused by this concept, you probably aren't ready to do that quite yet.)
Second mortgages for first time homebuyers, or "piggyback" loans:
Okay, okay, okay, so while that might have been confusing, here's what might apply to you: Though it sounds counterintuitive, longtime homeowners looking to use equity aren't the only people with a second mortgage. First-time homebuyers may opt to take out two mortgages at once if they can't afford a 20 percent down payment without taking on PMI. These are often referred to as "piggyback loans." These are commonly given out as 80/10/10 or 80/5/15 loans. This means that they are borrowing 80 percent of their home amount in a first mortgage with one fixed rate, 10 or 5 percent of their home value in a second mortgage with another, higher fixed rate, and supplying 10 or 15 percent as their equity through a down payment.
In some cases, this can work out as the best financial option for some. Since banks consider loans over 80 percent of the home value as higher risk loans, they often come with a higher interest rate and require PMI unlike those with 20 percent down payments or higher. Second mortgages can help lower this interest rate and get rid of PMI by breaking up that big loan: Instead of borrowing a lot of money with very high interest, some people get a first mortgage within the conforming loan amounts (what agencies like Fannie Mae and Freddie Mac set) and then a second mortgage to cover the remaining loan costs. "It is not uncommon for the combined payments to be less than a single loan with mortgage insurance," Boyaggi says. Additionally, for now, the interest on your second loan is tax-deductible (subject to interest deduction restrictions), but mortgage insurance payments are not.
When it comes to the second mortgage process—no matter what you use it for—it is of the utmost importance to remember that you are literally putting your home on the line. Additionally, keep in mind that you'll need to pay numerous costs for appraisals, credit checks, etc. If there is any real fear that you wouldn't be able to pay off a second mortgage, it is not the right loan for you.
Additionally, think about why you want one. If you want to buy a new Tesla, a second mortgage probably isn't the way to go. Instead, they're best use to improve financial standings (consolidate debt or improve equity) rather than create new financial problems.
And of course, don't base your financial decisions off this article: The best advice when it comes to considering whether a second mortgage is right for you is to talk to a reputable loan officer. While we want to give you all the information we can, their professional opinion matters most. It's also a good idea to speak to your tax preparer before you start taking deductions if you do take out (or plan to take out) a second mortgage.
At the end of the day, a second mortgage can be an ideal option for some people. Just be sure to make a calculated, educated, and professionally-informed decision before you sign on the dotted line.