If you're a borrower seeking funds for emergency expenses, you may be dismayed by the rates available on personal loans, which can average 10%–28%. However, if you're also a homeowner who has built up substantial equity, you may be in luck, as a second mortgage offers significantly cheaper rates than unsecured personal loans. This can make a second mortgage an attractive way to meet life expenses.
When Should I Consider a Second Mortgage?
People often turn to second mortgages when they're faced with major financial hurdles, such as emergency home repairs, debt consolidation or tuition costs. In these situations, a second mortgage can offer rates 10%–20% cheaper than rates on comparable unsecured loans. This is because a second mortgage is secured by your property, and therefore offers rates that tend to move in line with the mortgage market. By contrast, unsecured debts, like credit cards and personal loans, pose more risk to lenders and, consequently, feature higher interest rates.
Second mortgages come in both lump sum and revolving credit variants, which can be useful depending on your unique situation. Additionally, if you're planning on using your home equity for home improvement, the interest on your loan may be tax-deductible.
Despite the advantages, a second mortgage should not be taken lightly. As with any loan, you'll need to take inventory of your finances before making any decisions. Taking on additional debt is always risky: It’s harder to pay off, and much like standard mortgages, failing to pay could cause you to lose your property. Before taking out a second mortgage, be sure to consider all the factors, including whether it makes sense to leverage your home.
What Types of Loans Count as a Second Mortgage?
There are two types of second mortgages: home equity loans and home equity lines of credit (HELOC). A home equity loan is similar to a primary mortgage in that the lender pays you a single lump sum, which is usually repaid with a fixed term and rate. By contrast, HELOCs act more like credit cards in that you're given a credit limit, a variable rate and are required to make payments on a revolving basis.
When comparing the two options, a home equity loan is the better choice for large one-time expenses like debt consolidation or home renovation costs. The predictability of fixed monthly payments and finite terms make home equity loans useful for budgeting purposes. However, unlike credit cards, they don't provide much flexibility and don't offer additional credit after the initial payout.
A HELOC works well when you're forecasting regular expenses but don't know how much they might be: For example, you're planning to renovate your house, but don't know how much it will cost. HELOCs provide the flexibility to draw funds as needed without having to pay interest on a lump sum. Generally, a HELOC will offer ongoing access to credit for a limited time. During this "draw" period, you can spend, repay and reuse the funds up to the credit limit. Once the draw period ends, you’ll enter a repayment period, during which you'll make fixed monthly payments on your remaining balance.
How Much Should I Borrow on a Second Mortgage?
The amount you borrow should be limited to the amount you can comfortably afford to repay. Simply receiving approval from a lender is not proof that you can afford to take out more debt. A lender will not take your monthly living expenses into account, such as food and entertainment. A careful review of your finances is important to ensure you can afford to make payments on your new loan without negatively impacting your lifestyle.
Even if you can afford the additional payments, your lender may limit how much it lends based on the value of your home versus the combined balance of your first and second mortgages. This figure is called the combined loan to value (CLTV) of the property. Some lenders may limit your CLTV to 80%, while others may go as high as 90% or 95%. Your home’s value will be appraised and the lender will calculate a loan amount based on your appraised value.
In addition to CLTV, a lender also takes your debt-to-income ratio (DTI) into account when determining how much money to lend. Most banks follow Fannie Mae’s manual underwriting guidelines, which set a maximum DTI of 36% of your monthly income. For certain loans issued through Fannie Mae's automated underwriting service, the maximum DTI was raised to 50% as of 2017. You should consult a mortgage professional to discuss your specific circumstances.
Will Getting a Second Mortgage Affect My Credit?
A second mortgage can cause your credit score to go in either direction, depending on your payment habits. By consistently repaying your debt over time, an affordable second mortgage could actually boost your credit. However, be wary of taking on too much debt, as this may cause you to fall behind on your payments and damage your credit.
The formula for determining your score is complicated and differs by credit bureau. However, the three major credit bureaus take your payment history and the amount of debt you carry into account. In general, missed payments and high loan balances will negatively impact your credit, while consistent on-time payments and declining debts will improve your score.