How Does a Second Mortgage Work?

You may have heard the term “second mortgage,” but you may not understand what it is or how it works. A second mortgage may be helpful when you need to pay for something requiring a large sum of money that you don’t have the cash for, such as a kitchen remodel or sending a child to college. Using a second mortgage allows you to leverage the equity you have in your home to borrow the money.

What is a Second Mortgage?

A second mortgage is a home equity loan you take out using the equity you’ve built in your home, either through paying down (or making payments toward) the principle of the first mortgage or through an increase in the property’s real estate value. The lender uses your home as collateral to secure the loan, which is why these loans require a lien. They are termed “second” because they are subordinate to the first mortgage on your home.

You may have also heard second mortgages referred to as a HELOC, which stands for home equity line of credit. While a home equity loan delivers a lump sum of money to you at once, a HELOC is an available line of credit in which you can draw on up to the amount of credit available. For instance, if you have a HELOC of $40,000, you’ll receive checks you can use for the account which will allow you to withdraw up to $40,000.

How Does a Second Mortgage Work?

The first step toward having a second mortgage is getting approved by your financial institution. For example, at PSECU, we look at your credit score, pay stubs, and recent tax returns, to determine if you qualify.

The amount of your loan depends on how much equity you have built up in your property. This depends on two things — the value of your home minus any debt or other obligations using your home as collateral. The difference is your equity.

How do you determine your equity? The financial institution will assess the value of your home, based on comparable prices from your neighborhood, the condition of your home, any improvements you have made, and more. Each financial institution may have different rules about how much of your home’s value they will allow you to finance. Working with your financial institution, you can determine your home’s worth, equity, and how much of a second mortgage you’re eligible for.

Once you know how much of a second mortgage you’re eligible for, you can approach it one of the two ways we described above – take out a home equity loan as a lump sum that’s paid off in uniform monthly payments or open a line of credit, or a HELOC, with payments based on how much of the line of credit you use.

Regardless of which you choose, you will receive a term with your loan as well, which is the length of time you have to repay the loan. You’ll also get an interest rate, as you did with your first mortgage. Whether the interest rate is fixed or variable will depend on the type of loan, as well as any terms and conditions.

Lump Sum Loan vs. HELOC

There is a significant difference in how you pay back an equity loan versus a home equity line of credit:

• With a lump sum loan, you begin paying it back immediately and will pay back the entire sum gradually over a number of years encompassing whatever term you choose. You pay interest on the value of the entire loan. Typically, you’ll have a fixed interest rate.

• With a HELOC, you pay back only what you’ve borrowed, and the interest that accumulates on the money you have withdrawn. So, if you have a $100,000 HELOC but have only drawn $1,000 on it, you will only pay interest on $1,000, not $100,000. HELOCs are similar to credit cards, too, in that you can pay off a balance and then draw on it again. If you borrow $5,000, spend $5,000, but pay off $1,000 of that, you will have $1,000 to draw on anew.

Why Get a HELOC?

People choose to get home equity loans and lines of credit for a number of different purposes. Some of the most popular include:

• Remodeling a home

• Paying off credit card debt that carries a higher interest rate

• Financing their children’s education, such as college or prep school

• Consolidating other debt, such as medical bills

Is a Second Lien Mortgage Different from an Open-Ended Mortgage?

Yes. An open-ended mortgage allows borrowers to bump up the amount of their first mortgage. They must meet certain terms to do this, and the lender will generally set a limit on the total amount the loan can be increased. However, all the money still falls under the first mortgage, unlike the second mortgage, which is an entirely different loan.

Benefits of a Second Mortgage

Taking out a second mortgage offers a number of advantages to homeowners, including:

• Bigger borrows: If you need a great deal of money, a second mortgage may be your best bet to secure it. Depending on your current loan and financial situation, you may be able to draw up to 90% of your home’s value.

• Low interest rates: By putting up your home as collateral, you become less of a default risk. You can thus secure lower rates on second mortgages than you can on many other types of loans, such as a personal loan. However, because second mortgages are subordinate to first mortgages, they’re considered a bit riskier, and you’ll likely see interest rates that are a bit higher than first mortgage loans.

• Flexibility: The HELOC allows you to take only what you need. If you merely want a loan to draw on in case of an emergency, this may be a good option because you don’t pay for interest on money you aren’t using.

Find More Information About a HELOC

If you’re interested in learning more about a HELOC, check out our information on equity loans. You can also find more money management tips and resources on our WalletWorks page.

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