Maybe you need cash for a big purchase, like your kid’s tuition. Or you’re dreaming of renovating the kitchen. You already have a mortgage. Perhaps it’s time for a second mortgage.
A second mortgage is a loan secured against your home that’s separate from your initial loan (your primary mortgage), said Steven Millstein, a San Francisco–based certified financial planner. Since your second mortgage is based on the equity you’ve built in your home, it can allow you to borrow a substantial amount of cash with better terms than a credit card or personal loan.
“Most people use their second mortgage to consolidate debts, for home improvement and for paying for college tuition or real estate investing,” Millstein said. “Lenders consider these loans much safer, as they are secured against your house, which leads to much more competitive interest rates.”
When you get a second mortgage, you’ll still have to find a lender, get appraised, do the paperwork and pay all the fees (same drill as the first mortgage). But this time, you can choose a different mortgage broker if you want (hint: shop around again to get a good deal).
Types of second mortgages
There are two types of such loans: a home equity loan and a home equity line of credit.
Home equity loan (HEL). Similar to a standard mortgage, a home equity loan gives you a lump sum of money upfront based on the equity you have in your home. You make monthly payments with a fixed interest rate according to the loan terms. Your payments will be partially interest, partially principal.
Home equity line of credit (HELOC). This loan is more like a credit card: It typically has an adjustable interest rate, and you can borrow money when you need it, pay it back, and borrow again up to the credit limit. Again, the amount you receive is based on the equity you have in the home.
Reasons to take out a second mortgage
Perhaps you need cash for a big expense. It’s better to save up for a fun purchase such as a vacation or a boat. But getting a second mortgage can be a good option for funding important expenses that save or earn you money.
Here are a few reasons to do it.
- Avoid PMI. You can avoid private mortgage insurance (PMI) by using a combination of loans, Millstein said. PMI was created to protect lenders (it’s usually required when you can’t put down 20% for a property). Annual PMI fees range from 0.3% to 1.5% of the amount you borrow. You can cancel PMI when you own 20% or more of your home. So, when the balance on your first mortgage decreases and/or the value of your home increases, you might be able to cancel your PMI.One way to speed up this process is by taking out a second mortgage to pay for more equity in your home. The lender decides if this is possible.
According to Milstein, here’s an example of how it works: If you’re purchasing a $500,000 home, you can pay for it using a $350,000 primary mortgage, a $50,000 secondary mortgage and a $100,000 down payment. This strategy uses a piggyback loan to make sure your loan-to-value ratio is 80% or below.
“You just need to ensure this strategy makes sense in comparison to paying and then canceling PMI,” Millstein said. Borrowers will often find that it’s better to split their mortgages, as they can secure a better interest rate on the first loan, Millstein said. They then have the option of paying off the second loan faster and saving even more on interest.
“There is also an added benefit whereby you can deduct the interest you pay on both loans from your taxes; however, the second mortgage is only deductible up to the first $100,000,” he said.
- Home improvement expenses. This is a key area where second mortgages are popular, said Daniela Andreevska, San Francisco–based marketing director at Mashvisor, a real estate data analytics company that helps investors in the U.S. housing market make better and faster decisions. “You will not only benefit from tax deductions, but will also be able to sell your property for more or rent it out for more if you are an investor.”Bonus: If you use the money for substantial improvements on your home, you may get tax deductions under the Tax Cuts and Jobs Act.
- Education expenses. Since interest rates for education loans tend to be higher than those of second mortgages, some borrowers will take out a second mortgage to pay for educational expenses. If you aren’t able to make the payments, however, the lender can foreclose on your home, which is risky. And with changes in the tax laws, you should consider whether this is a smart option (more on this in later).
- High-interest debt. If you have credit card bills with double-digit interest, you might consider consolidating them and paying off credit card debt with a HELOC or home equity loan. You’ll pay less in interest.But keep in mind that you’re trading off unsecured debt for a loan that’s backed by your house. If you don’t pay off your credit cards, the worst that can happen is you will tank your credit score and have debt collectors calling. But if you don’t pay off your second mortgage, you could lose your house.
Steps to getting a second mortgage
The steps you’ll take to refinance a second mortgage are very similar to the steps you’d take to get your first mortgage.
- Qualify. Your lender will look at your credit score, your equity, your property value and your income to see if you qualify. The higher those numbers, the better your chance of qualifying.
- Get your finances together. Again, this is very similar to getting your first mortgage. You’ll have to show your credit score, your debt-to-income ratio and your documents from your first mortgage (if you’re applying to a lender that’s different from your first mortgage company).
- Gather documents. Financial statements including paystubs, tax documents and housing papers will be requested. Your lender will give you a list of their unique requirements.
- Shop around. You don’t need to take out a second mortgage with your original lender, and it’s important to shop around for the best HELOC rates or the best home equity loan rates, whichever type of loan you decide to go with. Make sure to compare interest rates, fees and the terms of the loan before committing.
Tax implications for second mortgages
There are new tax laws on the books, so it’s trickier to itemize the interest for second mortgages than it was before. In order to receive a tax deduction for your second mortgage, you have to use that loan specifically to improve your home or adapt it for other uses.
Prior to the Tax Cuts and Jobs Act, homeowners could deduct almost all interest on second mortgages on the first $1 million. But starting in 2018, you can now only deduct interest for home renovations, and only on the first $750,000 borrowed.
You can’t deduct interest for the following second mortgage reasons anymore:
- Debt consolidation
Second mortgage financing can be harder to obtain than a first mortgage, as it carries a higher risk for the lender, Andreevska said. “In the case of a foreclosure, your first mortgage will be paid first, and your second mortgage second, so that’s why lenders might ask for a higher interest rate for a second mortgage,” she said.
Nevertheless, a second mortgage can be a good option for homeowners because you can borrow a significant amount of money — often, more money than through a personal loan. You can also borrow that money at a lower interest rate than with other types of loans such as personal loans. Since you’re using your home as collateral, lenders see this as a relatively low-risk loan.
Just make sure you have the means to pay back the second mortgage because your house will be at risk. If you’re at all in doubt, it may be better to go with a different type of loan.