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What is a second mortgage, and how does it work?

Yahoo Personal Finance· Getty Images
Reyna Gobel
7 min read

If you have equity in your home and need to access a large amount of cash, you may not need to borrow money with a credit card. You can use a second mortgage to borrow against your home equity, often with lower rates and higher borrowing limits than other types of loans. A second mortgage is especially useful when you want to make home improvements or any other updates that could increase your home’s value.

We’ll discuss the types of second mortgages available for homeowners to access equity, the requirements for this kind of home loan, and the pros and cons.

Learn more: Types of mortgage loans

In this article:

With a second mortgage, you already have one home loan, and you add a new one alongside it. This is different from mortgage refinancing, which involves homeowners replacing their original mortgage with a new one.

Both your first and second mortgages are secured debts that use your home as collateral, and there are liens on your property until the loans are paid off. (A lien gives another entity the right to take your property in certain circumstances, such as foreclosure.) The second mortgage generally has a higher interest rate because if there’s a foreclosure, the original mortgage is paid off first. Thus, a second mortgage is a little less stable investment for a lender. Less stability + more risk for the lender = higher interest rate.

However, second mortgages are still less risky for a bank than a credit card because credit cards aren’t secured by an asset. This is why credit cards (and sometimes personal loans) have higher interest rates than secured loans.

Read more: Discover home equity review

As mentioned above, a second mortgage is a home loan that lets you borrow from your home equity. But what exactly does that mean? How do you borrow from equity, and how much can you borrow?

Home equity is the difference between your home's value and the amount you still owe. As you pay off your home, your equity grows. Home equity may also increase when market prices rise above what your home was valued at when you bought it.

For example, let’s say when you bought your house, it was worth $400,000 based on an appraisal of what your home was worth in your local real estate market at that time. You made a $40,000 down payment and borrowed the remaining $360,000 with a mortgage, so you have 10% home equity.

Now, let’s say the real estate market in your area has gotten more expensive. Your home appraises for $450,000 now. Plus, you’ve paid off another $60,000. How much home equity do you have now? Let’s do some quick math.

$40,000 (your original home equity) + $50,000 (home value increase) + $60,000 (the principal you’ve paid down) = $150,000 in equity.

With a second mortgage, your borrowing limit is limited by how much equity you need to keep in your home, which may vary by mortgage lender. If you needed to maintain 20% of your equity after taking out a second mortgage, you’d still have $60,000 available to borrow:

$150,000 - $90,000 (20% of your equity) = $60,000.

If your mortgage lender just requires 10% remaining equity for homeowners with a great credit score, you’d have another $45,000 available, totaling $105,000.

Dig deeper: Explaining loan-to-value ratio (LTV) and how it impacts your mortgage

Second mortgages are divided into two types: home equity loans and home equity lines of credit (HELOCs). Both are secured by your home, so making on-time repayments is crucial to keeping your home.

Home equity loans are second mortgages that give you the borrowed money in one lump sum. Home equity loans often have fixed interest rates and term lengths ranging from five to 30 years. You may choose a home equity loan if you feel confident about the amount of money you need or need all the cash at once.

A home equity line of credit (HELOC) is another type of second mortgage, but instead of receiving your money in one lump sum, you’ll have access to a line of credit with a variable rate. You will have a set number of years to tap the line of credit (known as the “draw period”).

For instance, your mortgage lender may say you can borrow money for 10 years. You could borrow $5,000 at one point and $10,000 at another. You just have to pay it off within the set timeline, known as the “repayment period.” Think of a HELOC as a low-interest credit card with a time limit.

Learn more: Adjustable-rate vs. fixed-rate mortgages

  • Equity in your home. You’re borrowing against the value of your home minus any outstanding home loan balances. Thus, if you don’t have enough equity in your home, there’s nothing to borrow. The exact amount of equity you need in your home to qualify for a second mortgage will vary by lender.

  • A credit score of at least 620. Some lenders could require credit scores of 680, or possibly higher depending on your personal finances.

  • A 43% debt-to-income ratio. Your debt-to-income ratio (DTI) is your monthly debt payments compared to your gross monthly income. The exact DTI required varies by lender, however, 43% or less is desirable for most lenders.

  • Relatively low interest rates. Second mortgage rates are usually lower than rates on credit cards, and depending on your situation, even personal loans. This can make a second mortgage loan a more affordable way to make home improvements or make a big purchase.

  • You don’t need to replace your current mortgage. Depending on when you bought your home, you may have a low mortgage interest rate right now. You'd lose that low rate if you refinanced and replaced your old home loan with a new one. But by taking out a second mortgage, you keep that low rate on your primary mortgage and only pay the higher rate on the second loan.

  • Tax benefits. Interest paid on your second mortgage might be tax deductible if you adhere to certain rules, such as using the money for home renovations.

  • Additional debt. You just added a second mortgage payment to your monthly debt. If you chose a cash-out refinance instead, you would keep just one mortgage payment while still pocketing cash from your home equity.

  • Costs. Although you’ll have fewer closing costs than with your existing mortgage, you’ll still have to pay for things like a home appraisal and credit check.

  • Risk of foreclosure. If you can’t make monthly payments toward both mortgages, you could lose your house in foreclosure.

Read more: Cash-out refinance vs. HELOC — Which should you choose?

A second mortgage, including a HELOC or home equity loan, can be a good idea if you have equity in your home and can afford the new monthly payments. Second mortgage rates are typically much lower than rates on credit cards.

Yes, a home equity line of credit (HELOC) is a type of second mortgage. You’ll make HELOC payments along with payments on your original mortgage.

You are taking on a second monthly housing payment, and getting a second mortgage costs money. You also risk losing your home in foreclosure if you stop making payments.

Second mortgages are a bit harder to get than first mortgages. There can be higher credit score requirements, and you need equity in your home to qualify.

This article was edited by Laura Grace Tarpley