When it comes to financial matters, it’s always best to weigh the pros and cons before you make large, irreversible decisions. This is especially true when the decisions involve the roof over your head. Second mortgages can be a smart way to manage debt and use capital or they can be an equity-draining leach on your monthly budget.
It all depends on how they’re used.
What is a second mortgage? A second mortgage is another note on your home that comes after the first mortgage. But before you jump, you have some research to do.
For instance, how do you compare a second mortgage vs. a home equity loan? What about second mortgage interest rates? And who are the best second mortgage lenders?
Benzinga answers all of these questions and more below.
What is a Second Mortgage?
Your first mortgage is the primary loan secured by your principal residence. A second mortgage is an additional loan, which uses your principal residence as collateral. “First” and “second” refer to the lien position of the mortgages.
The first mortgage is typically the larger amount, and since it was recorded with your county courthouse first, it holds the first lien position. The second mortgage is recorded in a subordinate, or second, position.
Lien position indicates a hierarchy in the event of a foreclosure. In a typical foreclosure, it’s assumed that the bank (lienholder) will not be able to recuperate 100% of its losses since foreclosed properties typically sell at a lower sales price. Once the home is sold, the money is applied to outstanding balances in lien position order.
The first mortgage is satisfied first, and then any leftover money is applied to a second loan balance and on down the line.
The order of payoff (first mortgage first, second mortgage next) poses a higher risk to the bank because it might not be compensated in the event of a foreclosure. Therefore, most second mortgage interest rates are higher than first mortgage rates but are still much lower than unsecured loan rates.
A second mortgage borrows against the equity in your home. Before you apply for a second mortgage, run the math and make sure you have existing equity to borrow against.
- First, estimate how much your home is worth. You can look at an old appraisal or the fair cash value on your tax assessment if that information is provided.
- Next, determine how much you owe on the mortgage. Use your current loan balance.
- Most lenders won’t lend more than 90% loan to value. Multiply the home value by 90% to calculate the maximum amount of money you can borrow against your home: $100,000 home value * 90% = $90,000.
- Take the 90% value limit and subtract what you currently owe for a rough estimate of the amount of equity that you can borrow against 90% LTV limit $90,000 – current mortgage balance $50,000 = $40,000
Types of Second Mortgages
There are two types of second mortgages: a home equity line of credit (HELOC) or a home equity loan.
A HELOC functions similarly to a credit card. You’re given a maximum credit limit, can borrow money from the line in any increment you wish and pay it down as you go. The balance can fluctuate depending on what you borrow and what you pay.
You only pay interest on the balance drawn. Most HELOCs are variable rate loans tied to an index rate, plus a margin. For example, a HELOC might be tied to the Wall Street Prime Rate (5.5% right now) plus a margin of .5%.
As the Prime Rate increases, so does the HELOC rate, and subsequently, your payment. HELOCs typically have a floor or ceiling rate which dictates that the rate can only go so low or so high. In a rising rate environment, a variable option might not be right for your needs.
If you’re funding many small projects and can pay down your balance in between projects, this might be a preferred option.
A home equity loan is a lump-sum loan, which means that upon closing, the entire amount is distributed to the borrower. The home equity loan requirements vary by lender, but the best home equity loan fits your specific needs. These loans are also typically fixed-rate loans: The payment will remain the same for the entire term of the loan.
The terms are shorter than a first mortgage loan to minimize risk exposure and to pay the loan off in a reasonable amount of time. From a budgeting standpoint, this is a better option if you need a large sum of money all at once.
When to Get a Second Mortgage
Understanding when to get a second mortgage is trickier than many other financial decisions. Not only are there good and bad reasons for borrowing against your equity, but there are also other alternatives to consider, such as a cash-out refinance.
If you have accumulated a mountain of credit card debt at an interest rate of 25%, it makes complete sense to use a home equity loan (or cash-out refi) to cover your balance with a much lower interest rate. Other forms of debt, like auto loans or personal loans, can be rolled into your home as well.
If you don’t have outstanding debt but know you’re going to have big expenses coming up (vacation to Aruba, a new supercomputer, etc.) it makes more sense to use a HELOC than a credit card to make these purchases. This will keep your monthly payments low and save on interest at the same time.
When is it better to cash out refinance?
A cash-out refinance happens when you refinance your mortgage for more than you owe and take the difference in cash. If interest rates have declined since you obtained your current mortgage, it’s usually a good idea to refinance. Keep in mind that there will be closing costs. Unless the decrease is significant enough, it may take a long time to recoup these costs.
If rates have increased and you have a lower fixed rate on your first mortgage, do not cash out refinance to simply cover some minor debts. This is a great opportunity to consider a second mortgage option or pay the higher interest rate only on a small portion of your overall debt.
Apply for a Second Mortgage
Once you decide what type of second mortgage suits your needs and have thoroughly researched second mortgage rates and they fit comfortably in your budget, it’s time to apply. Although qualification guidelines are slightly different, the application process is similar to a first mortgage. You will need to provide information regarding income, assets, credit and property value/condition.
The best place to start is often with your current mortgage lender, but, as always, apply to more than one lender and compare rates, fees and terms to ensure the best possible deal.
No form of home financing should be taken lightly. There are layers of risk, monthly budgets, and both personal and financial goals to consider. Furthermore, certain goals may not be in your best interest, so be sure to place them under serious scrutiny before borrowing against your hard-earned equity.
Frequently Asked Questions
1) Q: How much should I save for a down payment?
Most lenders will recommend that you save at least 20% of the cost of the home for a down payment. It is wise to save at least 20% because the more you put down, the lower your monthly payment will be and ultimately you will save on interest costs as well. In the event that you are unable to save 20% there are several home buyer programs and assistance, especially for first time buyers. Check out the lenders that specialize in making the home buying experience a breeze.
2) Q: How much interest will I pay?
Interest that you will pay is based on the interest rate that you received at the time of loan origination, how much you borrowed and the term of the loan. If you borrow $208,800 at 3.62% then over the course of a 30-year loan you will pay $133,793.14 in interest, assuming you make the monthly payment of $951.65. For a purchase mortgage rate get a quote here. If you are looking to refinance you can get started quickly here.
3) Q: How do I get pre-approved?
First, you need to fill out an application and submit it to the lender of your choice. For the application you need 2 previous years of tax returns including your W-2’s, your pay stub for past month, 2 months worth of bank statements and the lender will run your credit report. Once the application is submitted and processed it takes anywhere from 2-7 days to be approved or denied. Check out our top lenders and lock in your rate today!
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