What is a second mortgage and how does it work?

A second mortgage is a loan taken on top of the homeowner’s original mortgage, which is still being paid off. For a homeowner who has seen the value of their property increase over the past two years in the wake of the coronavirus pandemictaking out a second mortgage is an option that allows them to tap into their home equity and use it to finance important expenses such as home renovations, repay the debtor pay their child’s school fees.

How does a second mortgage work?

A second mortgage uses the equity in a home as collateral. Home equity can increase when a homeowner makes an additional mortgage payment, when appraisals in the neighborhood rise, or when the value of the home increases after improvements or renovations.

Although each lender has a different set of requirements, there are standard rules that most mortgage companies and banks follow, such as stating that a homeowner can borrow a maximum of 85% of the value of their home.

Starting with the current value of your home, you can determine how much money you can borrow in a second mortgage. If, for example, your home is worth $300,000 and a mortgage lender allows you to borrow 85% of the home’s value, the maximum amount you can borrow is $255,000.

$300,000 x 0.85 = $255,000

Next, subtract your mortgage balance. So if you still owe $200,000 on your primary mortgage, that means you can only borrow $55,000 for a home equity loan or HELOC.

$255,000 – $200,000 = $55,000

Types of second mortgages

The two most common types are home equity loans and home equity lines of credit, or HELOCs.

What is a home equity loan?

A home equity loan works similarly to a traditional loan where a homeowner receives a lump sum all at once. The loan is repaid by the owner at a fixed interest rate in regular monthly installments over a period of time, whether it be five, 15 or 30 years.

Small residential projects that are easily determined in cost, such as updating bathroom fixtures or replacing flooring, may be a good choice for a fixed amount loan. A HELOC, however, is often preferred for longer-term projects, such as building an extension to your home or renovating your kitchen, as this type of loan allows you to tap into the equity in your home. over several years.

Homeowners can also use money from a home equity loan to make additional payments on higher interest rate loans, such as credit cards.

Because home equity loans have a fixed interest rate over the term of a loan, payments remain constant. Although the interest rate on a home equity loan may be lower than that of a credit card or personal loan, the loan can extend for up to 30 years.

What is a HELOC?

Sometimes known as a home improvement line of credit, a HELOC is a type of home equity loan that acts as a revolving line of credit that you can access continuously for a set period of time. If you need money to pay for longer-term home improvement projects whose costs can fluctuate, a HELOC is an ideal option because you can withdraw money multiple times during your loan to fund your projects. .

The period during which you can withdraw money from your line of credit is called the drawdown period. It usually lasts 10 years. If you need access to cash, but don’t know how much you’ll need (or when you’ll need it), then a HELOC is the type of loan you need.

Example of using a HELOC as a second mortgage

A HELOC is a revolving line of credit that works like a credit card. Because the interest rate is often variable, your monthly payments can go up and down and won’t be consistent.

So, for example, let’s say your lender approves you for a $20,000 HELOC. You spend a total of $15,000 to remodel your kitchen. If you repay the $15,000 during the draw period, you can use the $20,000 again for another major expense, as long as it is during the draw period.

Lenders typically give homeowners a 10-year drawdown period to withdraw money from the loan. During this period, homeowners are only responsible for paying interest and not the full amount of the loan. The loan gives you another 20 years to repay the amount you borrowed plus interest.

Requirements for Applying for a Second Mortgage

Applying for a second mortgage requires a lot of paperwork and the steps involved are similar to getting a traditional mortgage.

Lenders check the same requirements to qualify for a HELOC loan or a home equity loan. Each lender has their own set of criteria when qualifying people for a home equity loan or HELOC, but the following checklist provides general criteria to get you started. To be eligible, you must have:

  • Home equity of at least 15% to 20%
  • A loan-to-value ratio, or LTV ratio, of 80% or less
  • Credit score must be, at minimum, in the mid-600s to qualify for either loan
  • Debt level should not exceed 43% of your gross monthly income

Special considerations when applying for a second mortgage

The loan-to-value ratio

The LTV ratio is used by lenders to assess the level of loan risk and determines whether homeowners qualify for a home equity loan. Lenders tend to stick to a loan-to-value ratio, or LTV ratio, of no more than 80%. Mortgage lenders, such as Fannie Mae and Freddie Mac, can approve home loans up to a maximum LTV ratio of 80%. A ratio of 80% or less is considered good. If your LTV ratio is above 80%, you are considered a risk to lenders and may be denied a loan. If you are approved for a loan with an LTV ratio above 80%, you may need to purchase mortgage insurance, which protects the lender in the event that you default on your loan and the lender has to foreclose on your home.

The LTV ratio is calculated by dividing the current loan balance by the appraised value of the home and expressing it as a percentage. In our previous example, if your first mortgage balance is $200,000 and the house is appraised at $300,000, simply divide the balance by the appraisal and you get 0.67, or an LTV ratio of 67%. . This means you have 33% of the equity in your home.

Approval time

The approval time to process and close a second mortgage is usually at least 30 days, as it takes time to provide the documentation required for a home equity loan or HELOC.

Second mortgage fees

Using a home equity loan or HELOC to pay for a renovation can be expensive because the list of fees is similar to what is paid for a traditional mortgage. Each lender has their own set of fees, so shopping around and reviewing the terms can help you compare these costs.

Should you get a second mortgage?

Tapping into the equity in your home can be the perfect solution to renovating your kitchen or reducing high-interest debt, but a second mortgage can be expensive and may require you to pay closing costs, as well as all the associated typical fees and expenses. with closing a loan, which means paying thousands of dollars in upfront fees if you choose to take out a HELOC.

When interest rates are higher, as they are now, a homeowner should consider a home equity loan because the payments are fixed. A HELOC can sometimes be a better option as interest rates fluctuate. For example, in a low interest rate environment, your payments might be lower, but they probably won’t be lower this year as rates are expected to continue to rise.

HELOCs and home equity loans can be long-term loans, so figure out how long you will live in your current home before committing to more debt, because if you sell your home, there are no assets left to secure. your loan, which means you are responsible for immediately paying the full balance of your HELOC loan.

The bottom line

A home equity loan and a HELOC are two forms of second mortgages that allow you to use the equity in your home. These funds can help you finance various home improvement projects, pay off debts or other major expenses.

Each lender has specific requirements to qualify for a home equity loan or HELOC, although they are often similar. Taking the time to research the benefits of a HELOC and a home equity loan can help you decide which one fits your needs and goals.

If you have a good credit rating, your home equity has increased, and you are eager to start a home improvement project that will add value to your home, then leverage your home equity through a HELOC or a home equity loan can be a good option.

FAQs

What is the difference between a home loan and a second mortgage?

A home equity loan is the same as a second mortgage. Homeowners usually already have an existing mortgage and use the equity in their home to borrow more money in the form of a home equity loan to pay for a renovation or other loans such as credit cards.

Are second mortgage rates higher than first mortgage rates?

Second mortgage rates tend to be higher than first mortgage rates because if a homeowner is unable to pay either, the first mortgage receives priority over payments. There is more risk when a homeowner borrows more money, so lenders consider this factor when loans are approved.

Should you opt for a home equity loan rather than a refinance?

Depending on your goals, a home equity loan may be more appropriate than refinancing your current mortgage. Refinancing is a good option as it will reduce your current mortgage payment and this money can be used to pay for a kitchen update. The money you save may not be enough for a larger renovation project, so figure out your renovation costs beforehand.

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