What Is a Second Mortgage and How Does It Work?

Types of Second Mortgages

There are two primary types of second mortgages: a home equity line of credit and a home equity loan. Both options for accessing your home equity differ based on how funds are distributed and repaid. 

1. Home Equity Line of Credit 

A HELOC is one type of second mortgage. 

Freedom Mortgage's HELOC allows you to borrow a lump sum upfront, then make redraws as needed during the draw period without submitting an additional application. You must meet the HELOC requirements, including having sufficient equity. Each new redraw is priced at the prevailing rate at the time of that draw, so the rate on a later redraw may differ from the rate on your initial draw.

Some other lenders offer HELOCs with no lump-sum distribution upfront, allowing borrowers to draw from a line of credit as needed. Compare HELOC rates, terms, and HELOC closing costs to see which loan is right for you.

2. Home Equity Loan

Home equity loans are another type of second mortgage. These loans allow you to borrow a lump sum upfront and pay it back over time. You cannot reborrow after the initial loan. Many have a fixed interest rate, so you will know your payment amount for the life of the loan.

How Does a Second Mortgage Work?

A second mortgage is a loan, in addition to your primary mortgage, that allows you to use your home as collateral to borrow against your home's equity. Similar to your primary mortgage, you submit an application, the lender will review and verify your information, and, if approved, funds will be distributed based on the loan type. 

You then make monthly payments on the second loan based on its rate and term. Unlike with your primary mortgage, though, the money you receive with the loan on a second mortgage takes the form of cash.

Both the first and second mortgage lenders have a claim on your home and can foreclose if you don't pay your bills. However, the original mortgage lender has the primary claim and will be repaid first before the second mortgage lender if you face foreclosure.

Requirements For a Second Mortgage

To get a second mortgage, you'll need to meet some basic lender requirements, which often include:

• Sufficient home equity so that, the combined first and second mortgage balances leave you with between 10%-20% of your home’s equity depending on your lender and loan type
• A maximum combined loan-to-value ratio (LTV) (the sum of your outstanding first and second home loan balances divided by home value) of between 80% to 90% depending on your lender and loan type.
• A healthy credit score—commonly a minimum requirement of 620 (Freedom Mortgage has a minimum of 640)
• The ability to provide financial documentation, such as proof of income, debts, and assets

Requirements vary by lender and the type of second mortgage, so review what's required before starting your application. For example, you may need an updated home appraisal.

Pros and Cons of a Second Mortgage

There are both pros and cons of a second mortgage. As the table below shows, the pros include borrowing at low rates without affecting your current loan, the option to use the money for almost any purpose, and extended repayment options. The cons include closing costs and an extra monthly payment.

The pros and cons also vary depending on your individual circumstances and what kind of second mortgage you choose. For example, while Freedom Mortgage offers a fixed interest rate per draw for its HELOC, some lenders offer variable-rate HELOCs, so you take the risk that your rate will change over time.

Remember, other financing options may be available if you decide a second mortgage isn't right for you. For example, a cash out refinance could give you access to the money you want, without having to manage an additional mortgage. By refinancing, the total finance charges may be higher over the life of the loan.

Is a Second Mortgage Right for You?

Deciding whether to take out a second mortgage is a major financial decision. Here are a few key things to consider when deciding whether it is right for you.

• Separate mortgage payments: You will need to make two monthly payments instead of one.
• Higher risk and rates: The rates are higher on a second mortgage than a first mortgage because the loan is riskier for the lender.
• Qualification requirements: You must have equity in your home and meet your lender's credit and income requirements.
• Second mortgage type: You can choose between a HELOC and a home equity loan. 

Second Mortgage vs. Cash Out Refinance

A second mortgage isn't right for everyone. If it's not the best choice for you, you have other options. 

For example, you could get a cash out refinance if you want to access cash while changing the terms of your current mortgage. A cash out refinance involves taking out one new loan, repaying your current mortgage, and borrowing more than your balance.

A cash out refinance loan has just one monthly payment, providing more simplicity compared to a HELOC. But you will change the interest rate on your current loan and reset your repayment timeline. By refinancing, the total finance charges may be higher over the life of the loan