When Should You Take Out a Second Mortgage?

Guest Post by Lyle Solomon

Second mortgage — the phrase is enough to catch your attention. Why would you need a second loan on your home if you already have one?

Second mortgages, commonly referred to as home equity loans, can be affordable financing to help you fulfill other financial dreams. And it would be worthwhile to consider what a second mortgage can accomplish for you when home equity is increasing quickly.

What is a second mortgage?

A second mortgage is a loan you take out against your property in addition to a primary mortgage. Home equity loans or home equity lines of credit (HELOC) are the most common examples of second mortgages.
 
If individuals have enough equity in their property, they can borrow against it with a second mortgage, whether a HELOC or a home equity loan. Your home's equity is determined by deducting the balance of your outstanding loans from the total value of your house.
 
It's not always possible to borrow the whole worth of your property. Banks and lenders typically only permit loans of up to 85 percent. For instance, if your home is valued at $400,000 (and is fully paid off), the most you could borrow would be $340,000. However, if you still owe $200,000 on your principal mortgage, you would only have $140,000 in equity for borrowing.

When it does or doesn't make sense to take out a second mortgage

There are a few scenarios when consumers should choose or ignore a second mortgage.

Scenario 1

When you need a massive amount of money for home improvements, you can consider a second mortgage. 
 
A prudent way to use your home equity would be to install a new kitchen or add a bedroom — two improvements that will almost certainly result in a significant boost in the value of your home.
 
You can consider a home equity line of credit to plan for unforeseen housing bills. In older homes, leaking roofs or outdated heating systems may necessitate expensive repairs. You might be able to pay for it using a HELOC, which has a considerably cheaper interest rate than a credit card or unsecured loan.
 
Since you borrow against the value of your home (which costs a lot of money), you can borrow up to 85 percent of your home's value. Home equity loans are secured loans and have a lower risk for lenders. For this reason, companies charge lower interest rates on these loans.

Scenario 2

When you are in debt with high interest rates, you can consolidate them with a second mortgage. Since the interest rates of home equity loans are usually lower than credit cards, personal loans, or payday loans, you can use home equity loans to pay off all your unsecured debts. For instance, you can consolidate payday loans or credit cards with a home equity loan to eliminate high-interest loans. 
 
Imagine you owe $10,000 on your payday loans at an interest rate of 350 percent. You may use funds from a second mortgage to pay off the payday loan because it would have a much cheaper interest rate in the long term.
 
Debt consolidation is one of the smartest ways to use a second mortgage. 

Scenario 3

Compared to home equity loans, cash-out refinances often offer lower interest rates. However, you could still be able to obtain a second mortgage if your lender denies your request for a refinance. Before you apply for a second mortgage, weigh all of your alternatives.

Scenario 4

Your borrowing limit depends on how much equity you have in your home. If you don't have 15–20 percent equity, staying away from a second mortgage is better because this is the minimum eligibility criteria set by most lenders.

Scenario 5

If you are not planning to stay at your home in the long term, it doesn't make sense to borrow a home equity loan. There is little point in increasing your debt load if you plan to sell your home within a few years.

If the interest rate of a home equity loan is too high, there is no need to opt for it.

What should you know before you get a second mortgage?

There are lots of things you should be aware of before you apply for a second mortgage:

1. You can lose your home to foreclosure in the event of loan default.
   
   
2. You can get tax deductions for the total interest paid.
   
   
3. The loan term can stretch from 1 to 20 years. The longer the loan term, the lower your monthly payments will be. Meanwhile, you have to make higher monthly payments for short-term loans. Talk about your financial situation with the lender and choose the best one for you.
    
   Long-term loans usually have lower interest rates. However, if you opt for a two-year loan term, the monthly payments will be pretty high. If you can't afford them, you will be in trouble.
   
   Always use a mortgage calculator to calculate your total interest payments and net savings before finalizing a deal. This is the best way to avoid mortgage debt.
   
   
4. You must submit a few documents when applying for the loan. For example, a copy of your credit report, your recent tax appraisal, a copy of the property deed, your current mortgage statement, a copy of your bank statement, W-2s, a copy of your pay stub, your tax returns for the past two years, your proof of income, etc.
   
   
5. You should fulfill the minimum credit score requirement. According to Experian, the minimum credit score requirement for a second mortgage is 620. A higher FICO score will help you qualify for better rates. Also, it is best if your debt-to-income ratio is lower than 43 percent.

Final note

The most vital thing is to use the money received from the second mortgage as effectively as possible, rather than using it to support your lifestyle. A second mortgage might be a good idea if you can use the money responsibly. 

Lyle Solomon has extensive legal experience, in-depth knowledge, and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California in 1998 and currently works for Oak View Law Group in California as a principal attorney.