If used responsibly, a second mortgage can act as a powerful tool to help you achieve your financial goals. First, though, you’ll want to think carefully about the potential benefits and risks of taking out a second mortgage on your home. It’s also wise to educate yourself on the best ways to use a second mortgage and whether this step is right for your needs.
How do second mortgages work?
A second mortgage is a loan you take out using your home’s equity as collateral. Equity is how much of your home you actually own. It’s based on your property’s value and how much of the original mortgage you’ve paid off. For example, if you’ve paid off $150,000 for a $400,000 home that has since grown in value to $500,000, your equity would be the amount you’ve paid off plus the increase in value. In an article for Bankrate, financial writer Michael Estrin notes second mortgages allow you to borrow up to 85 percent of your home’s value minus what you still owe on the first mortgage.
Second mortgages are typically issued in two different ways: as a home equity loan or a home equity line of credit. With a home equity loan, you get a fixed amount of money that you’ll then pay off with interest over a set term. With a home equity line of credit, you get a revolving amount of money to use over a “draw period” that can last for several years. According to an article by Miriam Caldwell for The Balance, this is similar to a credit card. As long as you keep up with minimum payments and don’t exceed your credit limit, you can keep drawing on it. Once the draw period is over, repayment will be due based on the loan’s terms.
Ways to use a second mortgage
Taking out a second mortgage can provide you with a significant financial boost. Instead of simply letting your home equity accrue, you can turn it into cash to put toward immediate objectives. Many homeowners fund home improvements with home equity loans or lines of credit, drawing on a house’s current worth to increase its future value. If you’re trying to repay high-interest debt, a second mortgage lets you consolidate that amount into one lower-interest loan. Second mortgages can also be used to pay for college or cover medical bills.
Benefits and drawbacks of second mortgages
The Balance’s financial advisor Justin Pritchard identifies three key advantages of taking out a second mortgage. Doing this lets you access larger loan amounts thanks to your home’s collateral, get lower interest rates than other loan types, and — in some cases — claim interest deductions on your taxes.
Second mortgages also come with several possible drawbacks. First among these is the simple fact that you’ll have to add a second mortgage payment to your budget. This can seriously strain your finances and even put you at risk for foreclosure if you take on too much extra debt. According to Pritchard, second mortgages also come with hidden costs like appraisals and origination fees. In addition, interest rates are usually a bit higher than they are for your first mortgage.
A second mortgage can be highly useful, but it’s not something you should take on lightly or use for casual spending. Before you commit to a home equity loan or line of credit, weigh the pros and cons, clarify your goals, and make sure the payments fit into your budget.