What Is a Second Mortgage? How Does a Second Mortgage Work? Get the Details

2017 Guide: What Is a Second Mortgage and How Does a Second Mortgage Work?

When someone says they’re getting a second mortgage, it can mean two completely different things: either they’re buying a second home, or they’re borrowing against the equity in their home

Let’s look at the home equity loan first.

Your home equity is the difference between the balance of your mortgage and the actual value of the house. You can borrow against this amount with a home equity loan.

What Is a 2^nd Mortgage?

What is a second mortgage in dollars and cents? Let’s say that your home is worth $175,000, and the amount you still owe on the mortgage is $100,000, you will be able to take out a second mortgage for a maximum of $75,000.

So how does a second mortgage work?

According to consumerfinance.gov, second mortgage loans are secondary liens against mortgaged homes. The lending bank places a lien against the property that is subordinate to the first mortgage. The lender will be second to receive the proceeds realized from selling your home if you go into foreclosure.

A second mortgage is a higher risk for the bank, since their lien will only recapture funds after the first lien is satisfied. Greater risk means you may face higher interest rates and greater scrutiny of your finances for this type of loan.

Different Types of Second Mortgage Loans

Image Source: What is a Second Mortgage

What is a second mortgage when it’s not a home equity loan?

It means that you have a mortgage for a second home. This is distinct from a home equity loan, and comes with a separate set of conditions, benefits, and potential liabilities.

The process of how to get a second mortgage is similar to the application for the first one.

Instead of using your home’s built up equity, you will be taking out a second mortgage for an additional home, totally separate from your first mortgage. One of your homes will not be a primary residence, and this will be reflected in your loan agreement.

You will have to plan carefully and seriously consider this question: how does a second mortgage work for you financially?

Let’s take a more detailed look at both these types of second mortgage loans.

What Is a Second Mortgage | Home Equity Loan

How does a second mortgage work?

Second mortgage loans that are taken out against your home’s equity work in a similar fashion to your original mortgage, with certain important differences.

One difference is that second mortgage loans are distributed directly to the borrower, either as a term loan or as a line of credit.
If you choose a term loan, the bank will distribute the loan as a lump sum, with a specific period of time to pay it back, at a set interest rate, just like your original mortgage.
A line of credit loan is more like a credit card. You will be allowed to withdraw up to the full amount of the loan as needed, and then pay off the principal, restoring the original credit amount.
Unlike a credit card, you must pay back the outstanding balance if you sell your home or when the term of the loan expires.

How Does a Second Mortgage HELOC Work?

What is a second mortgage HELOC?

A home equity line of credit is also called a HELOC, and it is a revolving line of credit. A HELOC will allow the borrower more flexibility than term second mortgage loans. You will also have a variable rate of interest that can fluctuate during the term of the loan.

This flexibility makes a HELOC great for expenses like ongoing home renovations. You can pay contractors and suppliers upfront for immediate work, and then pay that amount back to the bank slowly over weeks or months. Once you’ve replenished the HELOC, the next phase of work can be started.

The HELOC will allow you to make many large payments over the term of the loan, totaling several times the amount of the loan.

It’s important to plan your finances accordingly, because there are risks to taking out a second mortgage:

If you have a variable interest rate, a sudden increase may leave you scrambling come payment time.
It’s easy to overextend yourself, going into much greater debt than you planned for or can afford.
Sudden inability to pay off the credit balance at the end of the draw period would force you to obtain another loan to pay it off.
Poor planning or unforeseen emergencies can result in default and even bankruptcy.

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What Is a 2^nd Mortgage Debit Card?

You will use a debit card or special checks drawn on your line of credit to access your HELOC funds.

You can use a HELOC checkbook or debit card, just as conveniently as your normal debit card or checks, but potentially with more at risk.

Here are some of the results of overextending yourself financially:

Important renovations may be left incomplete, making your home uncomfortable to live in
Problems with other creditors due to late payments can cause financial distress
The possible repossession of items purchased on credit when you can no longer make the payments, damaging your credit
Defaulting on your mortgage and losing your home

Although the HELOC can be renewed at the bank’s discretion, you must be able to pay off your obligation at the end of the loan. You have to be responsible when taking out a second mortgage.

Just like term second mortgage loans, you’re also required to pay off the HELOC when you sell your home.

How does a Second Mortgage Work? The Term Loan

What is a second mortgage when it’s not a HELOC? These second mortgage loans are called closed end or term loans.

A term loan is paid to the borrower as a lump sum, and once you’ve received the money, you may not borrow further. Both HELOC and term second mortgages are usually for shorter terms than a first mortgage, typically 5-15 years.

You usually pay a fixed interest rate, although adjustable rate second mortgage loans are also available.

How to Get a Second Mortgage

Image Source: How to Get a Second Mortgage

Wondering how to get a second mortgage?

The process of getting a second mortgage is almost the same as for a primary mortgage.

When taking out a second mortgage, you will have to prove equity and show the same financial documents you did when you originally bought the house. The bank may scrutinize your financial situation more critically, since the risk for them is greater.

According to the Federal Trade Commission, there are closing costs and penalties to consider as well.

Closing Costs and Penalties

How does a second mortgage work regarding closing costs and fees?

These are questions you must ask when taking out a second mortgage:

What closing costs are included upfront? Application fees, an appraisal, title search, and legal fees can increase your costs substantially.
Are there continuing costs? Some lenders require fees to be paid for the life of the loan.
Are there special repayment terms? Be clear about whether monthly payments will cover both interest and principal and whether or not you’ll owe a large payment at the end of the loan.
Be absolutely certain about the circumstances under which the lender will consider you in default.

Things to Consider in Your Second Mortgage

The Importance of Equity

How does a second mortgage work from the bank’s point of view?

When taking out a second mortgage the bank must know how much equity you have in the home. For the bank your credit score and income, while an important consideration for second mortgage loans is only part of the equation.

Second mortgage loans are loans against the built up equity you have in your home. If you have no equity, taking out a second mortgage is not an option.

Paying Principal or Interest

How do second mortgages work with principal and interest?

Many home equity loans will only require interest to be paid for the first 10 years of the loan, the principal being included in the monthly payments afterward. Once the principle is included, monthly payments can increase dramatically.

If the borrower is not able to make the new payments, there will be a greater chance of default.

Make sure you find out how your payments will be structured before agreeing to a second mortgage loan.

Consider the Fees

Image Source: How Does a Second Mortgage Work

Mortgage lenders will charge fees whether you are applying for a first or second mortgage. The bank will charge:

Origination fees
Appraisal costs
Points, which is the fee to lower the interest rate on the loan, each point being 1 percent of the mortgage balance

Check with several lenders before agreeing to a loan, as fees can vary widely between lenders. Before signing any documents, ask for the fees in writing. In some states, fees that can be charged on second mortgage loans are limited; you should research the laws in your state.

What Is a 2^nd Mortgage Variable or Fixed Interest Rate?

You may apply for either a fixed or a variable rate loan. A fixed rate means that the percent of interest charged over the life of the loan will remain the same. A variable rate will fluctuate over the term of the loan, causing your monthly payments to change.

There are benefits to both types of loans:

Fixed interest rate loans will provide the security of knowing your payments are the same month to month
A variable interest rate loan can save you money if interest rates fall during the loan term, reducing your monthly payments

According to the FTC, a high credit score will both increase your chances of approval and help lower your rate of interest.

What Is a 2^nd Mortgage for a Second Home?

How do you get a second mortgage to buy another house? How do second mortgages work when you’re purchasing another home?

There are things both you and your lender need to know:

Your debt to income ratio
Your sources of income
Your credit score
What savings and assets you own
The amount of your down payment
If the home is to be your primary residence

Of course, the most important things that you need to know are:

What is a second mortgage you can afford?
Are you financially secure enough to make the payments over a period of years?

Once you have a mortgage for a second home, you are committed to making your monthly payments.

But not everyone buys a home to live in. How does a second mortgage work when you want to be a landlord?

What Is a 2nd Mortgage for Investment Property?

Second mortgage loans are a great way to begin investing in real-estate. You just have to buy a new home, choose which you want to live in, and offer the other for rent.

What is a second mortgage if you have a tenant to pay it?

Taking out a second mortgage can help you pay off your first loan, while your property continues to appreciate in value. Rent will pay one mortgage for you and then provide a source of income once that mortgage is paid off.

A Word of Caution

Call your lender and explain what you plan to do first. Your mortgage may limit or forbid converting your home into a rental. An article at sfgate.com explains why you should consider these points carefully:

You may have to pay a penalty to convert your home into a rental
There may be a long waiting period before you can begin to rent out your home
The bank may require you to refinance to an expensive, non-owner occupied loan
Once you change your insurance over to a landlord policy, the bank will know what you’re doing whether you tell them or not

But what is a second mortgage rental like? Will you be able to find someone willing to pay enough money to cover at least your monthly mortgage payment?

If your tenant has a blocked toilet, you’re the one who’ll get the call. You’ll also have to pay for routine maintenance and repairs. There may also be long periods between tenants when you’ll collect no rent at all.

Is being a landlord worth it to afford the mortgage for a second home?

Other Reasons for Getting a 2nd Mortgage

There are many other reasons for getting a second mortgage:

For many people, taking out a second mortgage is a way to consolidate debt, reducing monthly payments to one lower bill
Paying for medical expenses insurance won’t cover
A second mortgage can provide capital to start a new business
Taking a once in a lifetime trip, while you’re still young enough to enjoy it
To take advantage of an exceptional investment opportunity

What Is a 2^nd Mortgage to a Predatory Lender?

We live in an imperfect world, and unscrupulous people can be found in all industries. Being aware of what constitutes predatory lending practices will help you navigate away from a big financial mistake.

Some things you need to look out for when getting a second mortgage:

The lender is dishonest or hides important information about real costs, risks or loan terms
Unusually high interest relative to your credit score
Unreasonably high fees or charges
Prohibitively high prepayment penalties
The contract stipulates you may not take legal action against the lender, and may only use arbitration

But how do second mortgages work if you realize you’re working with a bad lender and change your mind? What do you do when second mortgage loans have already been signed with a predatory lender? You can take advantage of the FTC’s Cooling-Off Rule.

The Cooling-Off Rule and Second Mortgage Loans

According to the FTC, you are allowed three days to back out of a signed credit agreement. The lender must notify you of this right at signing, in writing. This is called the right of rescission, which is the right to rescind a signed agreement. The cooling off rule makes getting a second mortgage less stressful.

The borrower has a right to cancel the credit agreement for any reason, as long as the collateral is your principal residence. You may exercise this right until 12:00 am of the third business day. For cancellation purposes, Saturdays are included, but Sundays and legal holidays are not.

There are exceptions to the law that you must know:

You may not invoke your right to cancel if you are using property that you do not reside in
You cannot exercise this right for loans made to purchase a house

You will have to send a written rescission notice to the address and person specified to you by the bank for this purpose.

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Conclusion

Second mortgages come in many varieties, whether for an additional home or a new addition, through a HELOC or a fixed-rate loan. Regardless of your purpose in looking for the loan, you must do your due diligence in research to make sure that you find the right product, the right rate, and the right terms.

A second mortgage can be the beginning of a new adventure or even relief in a financially difficult situation. Either way, never sign on the dotted line until you understand everything within the loan, and make sure that you have full confidence in the second mortgage loan company and staff you are working with.

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