Considering taking out a second mortgage? Here are some advantages and disadvantages to taking out a second loan. (iStock)
A second mortgage is using your house as cash by using your home's available equity to help pay other debt or fund large expenses. You will be paying off this second mortgage in addition to your existing home mortgage.
The Consumer Financial Protection Bureau notes the term “second” refers to if "you can no longer pay your mortgages and your home is sold to pay off the debts, this loan is paid off second."
How does a second mortgage work?
The process for taking out a second mortgage is similar to the homebuying mortgage process, except this time the loan you’re taking out is based on the amount of equity available in your home. For example, if your home is worth $235,000 and the balance of your mortgage loan is $210,000, this means you may qualify to borrow $25,000 because that’s the amount of equity in your home.
The amount of home equity you have boils down to two things: how much you paid down your mortgage balance and how strong the housing market is in your area. A homeowner who’s been in their house long enough to make a dent in their mortgage balance, and/or one who lives in a hot housing market with rising home values, often benefit from having more equity at their disposal.
There are two primary types of second mortgages, so be sure and decide what type is best for you:
- Home Equity Loan – This is most common type and you can access it in one lump sum.
- Home Equity Line of Credit – Instead of taking out a pre-determined amount, you can access the funds as needed. It works like a credit card.
Process for taking out a second mortgage
If you are considering taking out a second mortgage, the first thing you should do is figure out exactly how much equity you have in your home. Determine your loan balance and what the house is currently worth. You can use any number of online real estate sites for an estimate of what similar homes are selling for in your area to help loosely calculate the amount you may borrow.
Once you have an estimated figure, it's time to do research. It’s great to get a few estimates and it may be easier to start the inquiry with the lending institution that holds your original mortgage. This can be a bank, credit union, mortgage broker or online lender. Don’t make the common mistake of not shopping around for mortgage rates.
Be sure and ask for a written loan estimate from each institution, then compare the annual percentage rate (APR) and fees on each. The lower your interest rate, the more money you’ll be saving in the long run. Make sure you check out your credit report and clear up any errors because the lender you chose will review your credit profile to determine if you qualify.
Is it a good idea to take out a second mortgage?
Homeowners may need to take out an additional loan for many reasons.
Maybe you’re feeling overwhelmed with high-interest debt, for example, and want to consolidate it into just one payment with a lower interest rate. Some other common reasons people turn to a second mortgage include paying for major home repairs and improvements, helping with college tuition, paying for costly medical procedures and assisting with large purchases.
But remember, there are two sides to every coin. While there are some obvious benefits to having a second mortgage there are also some disadvantages to be aware of.
- Lower interest rate. One of the big reasons people lean toward second mortgages is because it’s cheaper. With your home as collateral, the banks can afford to offer lower interest rates than unsecured loans.
- More cash on hand. You will have access to a larger portion of cash than what your credit card or other types of loans offer.
- Taxes advantages. When you take out a home equity loan, you may be able to deduct the interest paid on the second mortgage.
- Losing your home. Just as your house is collateral for the first mortgage, it will also be collateral for the second mortgage. If you’re unable to make payments, the bank could put a lien on your home and foreclose.
- Decreased equity. Chances are you’ll use most of the equity in your home for the loan. This will immediately diminish your home’s value and your personal net worth.
- Added costs. Although interest rates are lower than other types of loans, the rate for the second mortgage will still be higher than your original mortgage.
How much will a second mortgage cost me?
You won’t have to pay anything upfront when getting a second mortgage. But it’s important to note that there are other costs that may be associated with this type of loan.
Closing costs, for example, can be expensive. Then you may also be required to pay for the application fee, an appraisal, title fee and a host of other hidden costs that can add up if not negotiated beforehand.