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A second mortgage can be a home equity loan or a home equity line of credit taken out in addition to a regular mortgage. People obtain second mortgages in order to pay for home improvements, consolidate personal debt or to reduce the down payment on their primary mortgage. Because adding debt against the value of your house increases your risk of default, lenders charge higher interest rates for second mortgages.
- How Does a Second Mortgage Work?
- Second Mortgage Interest Rates
- Calculating Costs for a Second Mortgage
- Should You Get a Second Mortgage?
How Does a Second Mortgage Work?
You can apply for a second mortgage as a way to draw more money from the value of your house, but the process is significantly different from getting your first mortgage. In addition, second mortgages aren't meant to be used in the same way as a standalone home loan.
Basic Qualities of a Second Mortgage
- Higher interest rates due to increased risk of default
- Loan approval based on extra factors like CLTV
- Smaller loan amounts than the first mortgage
- Best used for expenses that create long-term financial benefit
Getting approved for a second mortgage is more complicated. In addition to the loan to value ratio (LTV) of your first mortgage, lenders evaluating a second mortgage application also rely on the combined loan to value (CLTV). Your CLTV shows the relationship between your home's value and the total amount of money you've borrowed against that value. Taking out additional mortgages increases your CLTV, so lenders impose a maximum on this figure to limit the risk of default.
As a rule, second mortgages involve lower amounts of money than your primary mortgage. These secondary balances are meant to go towards expenses that are smaller than your original home purchase. We would recommend these funds be better used for some long-term benefit rather than entertainment or regular needs. For example, people who get home equity loans often use them to pay for home improvement projects that are expected to increase the value of their homes when they're ready to sell and move on.
Second Mortgage Interest Rates
With a second mortgage, your interest rate will be significantly higher than for your first mortgage. While mortgage rates are always changing, you can typically expect the interest rate for a home equity loan or HELOC to be several dozen basis points above the average on a first mortgage.
Average Rates for Mortgage Products
|Loan Type||Rate||Loan Amount|
|30-year Fixed Rate||4.03%||$200,000|
|5-year Home Equity Loan||4.74%||$25,000|
|10-year Home Equity Loan||5.15%||$25,000|
|15-year Home Equity Loan||5.42%||$25,000|
These interest rates assume an LTV ratio of 80% on the first mortgage, which translates to 20% equity in your property. Considering that many homeowners haven't reached that level of equity, these second mortgage rates are an optimistic estimate. If your LTV ratio is higher than 80%, it's likely that lenders will charge you more expensive rates or turn down your application for a second mortgage altogether.
Lenders do this for several reasons. For one, raising the amount of debt secured by the same property makes it more likely that the borrower won't be able to pay it all back. More importantly, second mortgages are considered subordinate to the first mortgage: in a default, the lender holding the first mortgage must be paid in full before the second mortgage is repaid at all. Since this means that the lender of a subordinate loan may lose the entire amount, mortgage companies demand higher rates for second mortgages.
Calculating Costs for a Second Mortgage
If you're about to purchase your first home, you may know that it's possible to take out a second mortgage as a way to avoid private mortgage insurance costs. Imagine that you have $20,000 saved up towards a $200,000 home. With that amount, you'd be short of the $40,000 (20%) down payment required to eliminate mortgage insurance premiums. However, taking out a second mortgage for $25,000 with $5,000 (20%) down will leave you with $15,000 in savings and $25,000 in borrowed money —enough to pay 20% upfront on your first mortgage.
- $20,000 in savings covers 10% of a $200,000 home purchase
- Use $5,000 of savings for a 20% down payment on a $25,000 second mortgage
- Add remaining $15,000 in savings to $25,000 from second mortgage
- Pay $40,000 or 20% down on $200,000 first mortgage with no PMI
Used this way, a second mortgage can help you buy a larger property without spending extra on mortgage insurance every month. Obviously, you'll need to balance those monthly savings against the fact that a second mortgage comes with its own origination fee and monthly payment. If your interest rate is too high, that payment may be greater than the cost of your premium, and you would be better off with a single mortgage. Second mortgages may help some borrowers beat mortgage insurance, but you should compare the costs before you make a decision.
Should You Get a Second Mortgage?
Adding to your overall debt in any situation increases your risk, and second mortgages are no exception. We would not recommend putting your home on the line for extra money without a clear plan for how the funds will help your long-term finances. Using a home equity loan on improvements that raise your property value is one sensible option.
If you have another type of debt or loan that is charging much higher interest rates than a second mortgage would, getting a second mortgage might help you save money in the short term. For example, if you're paying high rates on unsecured personal loans, you might choose to consolidate that debt at a lower rate with a second mortgage. In this case, you should calculate and compare the total costs of each scenario.
Choosing a HELOC as your second mortgage is not quite as risky as borrowing a lump sum. Since HELOCs are a form of revolving debt, you can treat them like a credit card by paying off the amount you borrow every month. But like credit cards, HELOCs can spiral out of control if you start carrying a balance from month to month. The higher rates can inflate your balance past your ability to pay, putting your house at risk of foreclosure.