When you take out a mortgage to buy a home, the bank will let you borrow up to a certain percent of your home’s value. The difference between what your home is worth and what you owe on your mortgage is called equity.
Each month as you make your mortgage payment, you’re paying down your mortgage and increasing the amount of your equity. Additionally, the value of real estate typically goes up, and so your equity also increases as your home’s value increases.
A second mortgage allows you to pull that equity out of your home as cash or a line of credit. You’ll make monthly payments that pay off part of the balance of your loan, as well as interest that has accrued.
A second mortgage is a tool that can help you access a lump sum of cash that might not be available to you otherwise. But before you make the leap, here are a few things you need to know:
Home equity loan vs. home equity line of credit
There are typically two types of second mortgages: a home equity loan or a home equity line of credit (HELOC).
With a standard home equity loan, you’ll receive the amount you’ve borrowed as a cash lump sum. With a HELOC, your lender allows you to draw funds out of your line of credit and pay a variable payment amount each month. It’s similar to a credit card, but it is secured using the equity in your home.
How it works
Let’s say your home is valued at $250,000, and you’ve lived there for a few years. You owe $180,000 on your mortgage. If your lender allows you to borrow up to 90% of your home’s value, you could pull out as much as $45,000 in cash or as credit for your HELOC. You’ll need to fill out an application with a lender and be approved, just as you did for your initial mortgage.
Once you’re approved, you’ll pay for closing costs similar to your first mortgage – an appraisal fee and fees to the lender. Remember that if your lender advertises “No closing costs!” you are most likely still paying those costs with higher interest rates.
Your interest rate on a second mortgage will typically be higher than your interest rate for your first mortgage. This is because your lender is taking a higher risk. If you default on your mortgage payments and your home is foreclosed, the first lender would receive their money before the lender of your second mortgage.
However, interest rates on mortgages may still be lower than your interest rate for using a credit card or another form of borrowing, such as a personal loan.
Importance of making payments
The value of your home secures your second mortgage. This means that if you quit making payments, you could be at risk of losing your home due to foreclosure. Making payments on both your first and second mortgages should be at the top of your priority list each month.
Unlike your primary mortgage, you may not be able to deduct the interest from your second mortgage. According to the IRS, “Interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secured the loan.” In other words, if you’ve used your second mortgage or HELOC for anything other than significant improvements to your home, you may not deduct the interest for tax purposes.
Payments affect your credit score
Just as with any other form of borrowing, neglecting to make your payments or making late payments can affect your credit score. Your credit score may also be affected negatively if you borrow the maximum available credit to you (for example, if your credit cards and your HELOC are both maxed out).
Common uses of funds
Second mortgages are often used for major home improvements, college tuition, vehicle purchases, weddings, or debt consolidation. HELOCs are commonly used for a series of minor home improvements when the cash isn’t needed all at once. While these are common uses for this type of mortgage, before you sign the dotted line be sure that you are willing to put your home at risk to secure these items.
A second mortgage can be a useful tool for borrowing large amounts of money that may not be accessible to you otherwise. However, like any type of borrowing, there is risk involved. In this case, you’re putting up your home for collateral on your loan. Make sure you can afford your new monthly payments and use caution before borrowing against your equity.