A second mortgage is a loan made in addition to the homeowner’s original mortgage, which is still being repaid. For a homeowner who has seen the value of their property increase over the past two years in the wake of the coronavirus pandemic, taking on a second mortgage is an option that allows them to tap into their home equity and use it to fund such major expenses as home renovations, pay down debt, or pay for their child’s college expenses.
How does a second mortgage work?
A second mortgage uses the equity in a home as collateral. Home equity can increase when a homeowner makes an extra mortgage payment, when valuations in the neighborhood rise, or when the value of the home rises after upgrades or renovations.
While each lender has a different set of requirements, there are standard rules that most mortgage companies and banks follow such as establishing that a homeowner can borrow a maximum of 85% of the value of their home.
By starting with the current value of your home, you can determine how much money you can borrow in a second mortgage. If, for example, your home is worth $300,000 and a mortgage lender lets you borrow 85% of the value of the home, then the maximum amount you can borrow is $255,000.
$300,000 x 0.85 = $255,000
Next, subtract the balance on your mortgage. So, if you still owe $200,000 on your primary mortgage, that means you can borrow only $55,000 for a home equity loan, or HELOC.
$255,000 – $200,000 = $55,000
Types of second mortgages
What is a home equity loan?
A home equity loan operates in a similar fashion to a traditional loan where a homeowner receives a lump sum at one time. The loan is paid back by the homeowner at a fixed interest rate in regular monthly installments over a period of time, be it over five years, 15 years or 30 years.
Smaller home projects where the cost is easily determined, such as updating bathroom fixtures or replacing flooring, can be a good choice for a loan with a fixed amount. A HELOC, however, is often preferred for longer term projects, such as building an extension on your home or remodeling your kitchen, because this type of loan lets you tap into your home’s equity over several years.
Homeowners can also use the money from a home equity loan to make extra payments on loans with higher interest rates such as credit cards.
Because home equity loans have a fixed interest rate during the life of a loan, the payments remain constant. While the interest rate on a home equity loan can be lower compared with a credit card or a personal loan, the loan can stretch for as long as 30 years.
What is a HELOC?
Sometimes known as a home improvement line of credit, a HELOC is a type of home equity loan that acts as a revolving line of credit that you can access continually over a period of time. If you need money to pay for longer-term home improvement projects in which costs can fluctuate, a HELOC is an ideal option because you can repeatedly withdraw money over the course of your loan to fund your projects.
The period of time in which you can withdraw money from your line of credit is known as the draw period. It typically lasts 10 years. If you need to access money, but are uncertain as to how much you’ll need (or when you’ll need it), then a HELOC is the type of loan you need.
Example of using a HELOC as a second mortgage
A HELOC is a revolving line of credit that operates like a credit card. Because the interest rate is often variable, your monthly payments can go up and down and won’t be consistent.
So, for example, let’s say your lender approves you for a $20,000 HELOC. You spend a total of $15,000 to remodel your kitchen. If you pay back the $15,000 within the draw period, then you can use the $20,000 again for another major expense, provided it’s within the draw period.
Lenders typically give homeowners a draw period of 10 years to take out cash from the loan. During that period, homeowners are only responsible for making payments on the interest and not the full loan amount. The loan gives you another 20 years to pay back the amount you borrowed along with the interest.
Requirements for applying for a second mortgage
Applying for a second mortgage requires a lot of paperwork and the steps involved are similar to obtaining a traditional mortgage.
Lenders check for the same requirements to qualify for either a HELOC or a home equity loan. Each lender has its own set of criteria when qualifying people for a home equity loan or HELOC, but the following checklist provides general criteria to help you get started. To qualify, you should have:
- Equity in the home of at least 15% to 20%
- A loan-to-value ratio, or LTV ratio, of 80% or less
- Credit score must be, at minimum, in the mid-600s to qualify for either loan
- Debt level shouldn’t exceed 43% of your gross monthly income
Special considerations when applying for a second mortgage
The loan-to-value ratio
The LTV ratio is used by lenders to assess the level of lending risk and determines whether homeowners qualify for a home equity loan. Lenders tend to stick to a loan-to-value ratio, or LTV ratio, of no more than 80%. Mortgage lenders, such as Fannie Mae and Freddie Mac, are able to approve home loans up to a maximum LTV ratio of 80%. A ratio of 80% or less is considered good. If your LTV ratio is above 80%, you’re considered a risk to lenders and may be declined for a loan. If you do get approved for a loan with and LTV ratio higher than 80%, you may need to buy mortgage insurance, which protects the lender in case you default on your loan and the lender needs to foreclose on your home.
The LTV ratio is calculated by dividing the current loan balance by the home’s appraised value and expressing it as a percentage value. In our previous example, if the balance on your first mortgage is $200,000 and the home is appraised at $300,000, simply divide the balance by the appraisal and you get 0.67, or an LTV ratio of 67%. That means you have 33% of equity in your home.
The approval time to process and close a second mortgage is typically at least 30 days as it takes time to provide the required documentation for a home equity loan or HELOC.
Second mortgage costs
Using a home equity loan or HELOC to pay for a renovation can be costly because the list of fees is similar to those that are paid for a traditional mortgage. Each lender has its own set of fees, so shopping around and reviewing the terms can help you compare those costs.
Should you get a second mortgage?
Tapping into the equity of your home can be the ideal solution to pay for renovating your kitchen or reducing high interest debt, but a second mortgage can be costly and may require you to pay closing costs, as well as all the typical fees and expenses associated with closing a loan, which means paying thousands of dollars in upfront costs if you choose to take out a HELOC.
When interest rates are higher, as they are now, a homeowner should consider a home equity loan because the installments are fixed. A HELOC can sometimes be a better option because interest rates fluctuate. For example, in a low interest rate environment, your payments could be lower, but they likely won’t be this year as rates are expected to keep rising.
Both HELOCs and home equity loans can be lengthy loans, so determine how long you will live in your current home before signing up for more debt, because if you sell your home there is no asset left to secure your loan, which means you are responsible for paying the entirety of your HELOC loan balance immediately.