When Should You Get a Second Mortgage?

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If your home is worth more than what you currently owe on your mortgage, you can use that extra equity to take out a second mortgage. With better rates and loan terms than an unsecured loan, a second mortgage can be an attractive way to meet other life expenses. However, you should only consider a second mortgage after carefully considering how the additional debt will affect your financial health.

When Should You Get a Second Mortgage?

People often turn to second mortgages when they're faced with major financial hurdles, such as a needed home repair or renovation, debt consolidation, or college tuition. There are many different factors to consider when weighing your options, such as whether it makes sense to leverage your home as security for a loan.

Despite the potential advantages, taking out a second mortgage should not be taken lightly. As with any financing option, you'll need to take an honest and thorough inventory of your finances before making any such decision. Taking on additional debt is always a risk: it’s harder to pay off, and failing to pay could mean losing your property.

What Types of Loans Count as a Second Mortgage?

Generally there are two types of second mortgages: a home equity loan and a home equity line of credit (HELOC). A home equity loan is similar to a primary mortgage in that you receive a single lump sum from the lender, usually with a fixed term and a fixed rate. A HELOC acts more like a credit card in that you're given a credit limit and pay a variable rate on a revolving monthly balance.

When you compare the two options for a second mortgage, a home equity loan is the better choice for large non-repeating expenses like debt consolidation or a major home renovation. The predictability of fixed monthly payments and a finite term make home equity loans easier when it comes to budgeting. However, they don't offer much flexibility, and you won't have any access to additional credit after the initial payment.

A HELOC works well when you need smaller sums of extra money on a repeating basis. For example, you might want to finance a new car and plan to tile your kitchen. HELOCs provide more flexibility for these smaller, periodic purchases. Generally, HELOCs give you ongoing access to credit for 10 years. 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 20-year repayment period.

How Much Should I Borrow on a Second Mortgage?

As in any financing situation, the amount you borrow on a second mortgage should be limited to the amount you can comfortably afford to repay. Simply receiving approval from a lender is not always proof that you can afford the loan you're seeking. A lender will not take into account all your monthly expenses, such as food and entertainment. A careful analysis of your finances is important to ensure you can afford the payments of the loan without a significant impact on your lifestyle.

Even if you can afford the additional monthly payments of a second mortgage, your lender will limit how much it's willing to lend based on the value of your home versus the total combined amount of your first mortgage and second mortgage. 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 determined by an appraisal ordered by the lender and paid for by you. The lender will then calculate a loan amount based on your appraised value.

In addition to CLTV, a lender will take into account your debt-to-income ratio (DTI) when determining how much money to lend. Most follow Fannie Mae’s underwriting guidelines, which set a maximum DTI of 36% of your monthly income. That maximum DTI can be increased to 45% if you meet certain credit score and cash reserve requirements. These limits are flexible, and you should consult a mortgage professional to discuss your specific circumstances.

Will Getting a Second Mortgage Affect My Credit?

Obtaining a second mortgage will affect your credit score because it adds to your outstanding debt. The formula for determining your score is complicated and differs among each credit bureau. However, they all generally take into account your payment history and the amount of debt you carry.

The more debt you have, the more likely it becomes that you'll default, resulting in a lower credit score. In addition, missed payments can be reported to credit bureaus and negatively affect your credit score. A good payment history, on the other hand, generally helps to improve your credit score.

With a second mortgage, your credit score can go in either direction, depending on how well you manage your payments. By providing another opportunity to make on-time payments, an affordable second mortgage could actually help boost your credit. Conversely, taking on too much debt will lead you to fall behind on your payments and hurt your score.

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