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Mortgage Basics

What Is a Second Mortgage?

A second mortgage is a loan that uses your house as collateral. More specifically, it uses your equity in the house—the percentage of its resale value that you own outright—as collateral. That's why second mortgages are also called home equity loans.

When you finance your home with a mortgage loan, your equity starts with your down payment. You gain more equity with each payment you make, until your final payment takes you to 100% equity. Because your home is collateral, you'll lose it if you stop making payments.

Types of Second Mortgages

There are two main types of second mortgages:

  • Home equity loan. With a home equity loan, you borrow a lump sum you'll pay back in a series of equal monthly installment payments over a repayment period, such as 10, 15 or 20 years. This type of second mortgage is often used for a single big-ticket expense (a roof replacement or a major renovation) for which the cost is known and fixed, and can be fully covered by the loan amount.
  • Home Equity Line of Credit (HELOC). A HELOC is a type of revolving credit, with usage and repayment terms similar to that of a credit card: The amount you borrow establishes a credit limit against which you can make purchases by writing checks or using a debit card issued by the lender. You must make a minimum payment each month, but otherwise you can repay as much or as little as you like. As you pay down your balance, your borrowing limit is restored. You are charged interest only on your outstanding balance. A HELOC often makes sense if you're working on a series of home improvements, need to make sizable upfront investments in labor and materials for each, and can pay down those costs as you go.

Common Reasons for a Second Mortgage

Access to relatively large amounts of money makes second mortgages popular for covering major expenses. You can use funds from a second mortgage for anything you like, including:

  • Consolidating and paying off existing debt, especially high interest loans and credit card balances
  • Launching or investing in a small business (as a supplement or alternative to an SBA Loan)
  • Medical debts
  • College tuition and other expenses
  • Purchasing a car, boat or recreational vehicle

Second mortgages are also often used as home improvement loans, to cover expenses for major repairs (a new roof or HVAC system, for instance), renovations (room additions, bathroom remodeling and the like), landscaping projects or even a down payment on a second home.

One advantage to using second mortgage funds to fix up your home is that under the 2017 tax reform law, the interest you pay on a second mortgage loan is deductible from your federal income tax, but only if the loan is used to "buy, build or substantially improve" your home.

Using second mortgage funds to improve a house also can be a good way to increase the home's resale value. Depending on the age of the property, the nature of the renovations and the strength of the local housing market, judicious improvements can more than pay for the amount of the loan upon sale of the house.

How Do You Qualify for a Second Mortgage?

Typically, to qualify for a second mortgage, you'll need around 20% equity in your home. The lender will arrange an appraisal, which you'll have to pay for, to determine the market value of the home.

The thoroughness of the required appraisal will vary by lender. A full appraisal, entailing a walk-through of the home, could cost $500 or more. But a growing number of lenders allow much cheaper exterior-only appraisals. Some lenders even allow "desktop appraisals" that use local housing data to calculate market value that may cost under $100 or even be provided free to applicants.

When Does It Make Sense to Take Out a Second Mortgage?

The ideal circumstance for taking out a second mortgage may be to finance home improvements that significantly enhance the value of your home. Whether you plan to sell your home soon or stay long term and take advantage of the improvements, you'll typically see a good return on your investment. Some home improvements yield bigger returns than others, however, and depending on the housing market, some may yield no return at all; for example, a built-in swimming pool is practically essential in some locales, but in other areas one may discourage buyers. It's your home, so improve it as you wish, but if enhancing resale value is your goal, it might be wise to consult a real estate professional to help prioritize your projects.

A second mortgage may also make sense if you're overwhelmed with high interest debt, and a home equity loan will enable you to reduce your monthly payments (and interest costs) to a manageable level. Of course, this strategy will only work if you can avoid running up additional debt like the ones that got you in trouble to begin with.

Because home equity represents the largest portion of many families' wealth, a second mortgage may be the only option to cover large unexpected expenses, including medical emergencies or emergency home repairs.

Why a Second Mortgage Might Be Risky

While the borrowing terms on second mortgages are fairly reasonable, they can represent a significant monthly expense: Interest rates on home equity installment loans vary from market to market and lender to lender, but national rates currently range from just under 3% to 11%, and HELOC rates range from about 3.5% to 13%. Origination fees on home equity installment loans, which are negotiable and can often be rolled into monthly payments, range from 2% to 5% of the loan amount.

The biggest downside to a second mortgage is the possibility of losing your home in the event you can't make your payments. If you're concerned that you may be unable to juggle both mortgages, it would probably be wise to look into other financing options or, worst case, sell the home and trade for a more affordable housing option.

Is a Good Credit Score Needed for a Second Mortgage?

As with a conventional mortgage, your credit score plays a role in determining the interest rate and payment terms you'll get on a second mortgage.

Requirements differ around the country, but lenders tend to look for a minimum FICO® Score* of about 620 from second mortgage applicants. All other factors being equal, the higher your credit score, the lower your interest rate is likely to be.

Lenders also consider your debt-to-income ratio (DTI)—the portion of your gross monthly income that goes toward debt payments. Most lenders prefer applicants with a DTI below 43%, though exceptions are possible (especially if you show that the loan will reduce your monthly DTI).

If you're thinking about getting a second mortgage for non-emergency purposes, it may be worth spending six to 12 months working on improving your credit score before you start shopping for a loan. These steps can help you get started, and can bring relatively quick improvements to your credit scores:

  • Check your credit reports and credit scores so you know where you stand, and make sure the information in your credit reports is accurate. If you find any inaccuracies, you can dispute them with the credit reporting agencies (Experian, TransUnion and Equifax). Your credit report will show you where your credit may need improvement, such as late payments or a short credit history.
  • Pay down debt. Paying off high credit card balances lowers your DTI and can also help improve your credit score. Your credit utilization rate—how much credit card debt you have in relation to your total available credit—is an important factor in your credit score. Get your credit utilization rate as low as possible (think single digits) to see the biggest improvement in your scores. Ideally, don't carry any debt from one month to the next.
  • Don't apply for new credit. When you apply for a loan or credit card, the lender typically makes a hard inquiry on your credit report, which can cause your credit score to drop by a few points temporarily. Adding new debt can also increase your DTI.

Bottom Line: It Depends

A second mortgage can be a powerful tool for accessing cash to meet your needs and accomplish your goals. Compared with an unsecured personal loan, a second mortgage may allow you to borrow a larger amount and get it at a lower interest rate—depending on the amount of equity you've accrued in your home.

As long as you are confident you can cover your payments, a home equity loan or HELOC can be a great vehicle for taking advantage of the wealth you've built up in your home.

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