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How to choose between a second mortgage vs. refinance
If you have a significant goal, like paying off credit card debt or renovating your kitchen, you may be interested in tapping into your home equity to help you afford it. You can access your home equity — what your property is worth minus what you still owe on it — in several ways, including taking out a second mortgage or refinancing your existing mortgage loan.
But how do you decide which makes more sense for your situation? Here’s how to choose between a second mortgage and refinance.
Read more: The best mortgage refinance lenders
In this article:
What is a second mortgage?
A second mortgage is exactly how it sounds. You take out another home loan on your residence — in addition to your existing housing debt — and repay the two notes concurrently. Second mortgages come in two forms: a home equity loan or a home equity line of credit (HELOC).
Sometimes you can get a HELOC with only 15% equity in your home, but it’s common for both financial products to require at least 20% home equity to qualify. For example, if your home is worth $300,000, your primary mortgage balance must be $240,000 or less to secure financing.
Second mortgages typically charge higher interest rates because your lender takes on greater risk. If you default on your housing debt, your primary mortgage will be repaid first when the property is foreclosed on and sold.
While both types of second mortgages can help you access the money you need, there are some fundamental differences. Here’s how they compare:
Home equity loan
With a home equity loan, you receive a lump sum at closing and begin making monthly payments pretty much immediately. Generally, home equity loans charge fixed interest rates, so your monthly payment will likely remain stable throughout the repayment term.
HELOC
A HELOC has two distinct phases: the draw and repayment periods. During the draw period, which often lasts up to 10 years, you can spend up to your credit limit, pay down your balance, and repeat the process. Your lender may allow interest-only payments during this time.
During the repayment period — which typically lasts for 20 years — you can no longer use your credit line and must make principal and interest payments until the debt is paid off. HELOCs usually have adjustable mortgage rates, so your monthly payment may change during the loan term. Some mortgage lenders allow you to switch to a fixed rate during your repayment term, though.
Dig deeper: HELOC vs. home equity loan — How to choose
How does a mortgage refinance work?
Unlike a second mortgage, a mortgage refinance pays off your original mortgage with a new one. Your new mortgage loan will likely include a different interest rate, a new repayment term, cash back, or some combination of the three. There are two main types of refinancing: rate-and-term and cash-out.
Like a home equity loan or HELOC, you’ll need about 20% equity to be eligible for a refinance. If qualified, your interest rate may be fixed or adjustable. Since your lender will be first in line to get paid should you default, you should get a lower interest rate with a refinance than a second mortgage.
Both rate-and-term and cash-out refinances result in a new mortgage, but they have distinct purposes. Here’s how they compare:
Rate-and-term refinance
With a rate-and-term refinance, you simply replace your original mortgage with a new one. You use the money from your new loan to pay off the first mortgage, then start making monthly payments toward your new mortgage. You may choose this type of refinance to lower your interest rate, change your repayment term, or both.
Cash-out refinance
With a cash-out refinance, you borrow more than your original mortgage balance. You then use the difference to pay off high-interest debt, update your residence, or cover another expense. Your new home loan may have a different interest rate or repayment term than your initial housing debt.
Learn more: Want to refinance your mortgage? Here are 7 home refinance options.
Pros and cons of second mortgages
A second mortgage can be a viable way to access your home equity, but it has perks and pitfalls.
Pros
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Keep your original mortgage terms (for example, if you have a super-low interest rate, you don’t lose it by refinancing)
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Closing costs are usually lower than with refinancing
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Choose between receiving a lump sum (home equity loan) or line of credit (HELOC)
Cons
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Must juggle two housing debts simultaneously
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Potentially higher interest rate than your primary mortgage
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Can lose your home if you don’t make mortgage payments
Learn more: What to expect when facing foreclosure
Pros and cons of refinances
Refinancing your mortgage can help your financial situation, but just like getting a second mortgage, it comes with advantages and disadvantages.
Pros
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Only one housing debt to manage
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Potentially lower interest rate than your original mortgage or a second mortgage (depending on your current mortgage’s rate)
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Can receive a lump sum with a cash-out refinance
Cons
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Closing costs are usually more expensive than with a second mortgage
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Inconvenient option if you do not want to change the terms of your current mortgage
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Can lose your home if you don’t repay the new mortgage as agreed
Dig deeper: 6 times when it makes sense to refinance your mortgage
Which option should you choose?
No one knows your circumstances better than you do, so the decision is ultimately up to you. We asked financial experts weigh in with their take to help guide your thinking.
A refinance could work “... if interest rates are lower than your current first mortgage interest rate. Depending on your loan balance, it could make sense [to refinance] when interest rates fall 1-2% lower than [what] you currently have,” said Chuck Meier, senior vice president and mortgage sales director at Sunrise Banks, via email.
But, if your original mortgage has a low interest rate you don’t want to lose by taking out an entirely new loan, a second mortgage may be a better choice.
However, Jeremy Zuke, a financial planner with Abundo Wealth, had a warning for people considering a second mortgage. “... just be careful about thinking of it like an ATM on your house. That's how a lot of people get in big trouble overextending themselves for home renovations or other expensive purchases,” Zuke said via email.
Read more:
Second mortgage vs. refinance FAQs
Is it better to refinance or get a second mortgage?
It may be better to refinance your existing home loan if you can secure a better interest rate. However, taking out a second mortgage may be your best move if you’d prefer to preserve the terms of your original loan.
Is the home equity loan or HELOC a better second mortgage?
A home equity loan may be better if you want to borrow a lump sum with a fixed interest rate. On the other hand, a HELOC could be the right fit if you’re not sure how much you need to borrow, want access to a credit line, or want to delay full monthly repayments until the end of the draw phase.
Are there alternatives to getting a second mortgage or refinancing my existing home loan?
“I firmly believe it is always in the homeowner’s best interest to leave their equity alone [when] possible,” said Meier. Meier suggested exploring interest-free financing options for home improvement projects. He also noted that obtaining a personal loan could be a good way to get the money you need without putting your home at risk.
This article was edited by Laura Grace Tarpley.
