What Is a Second Mortgage?
A second mortgage is a type of subordinate mortgage made while an original mortgage is still in effect. In the event of default, the original mortgage would receive all proceeds from the liquidation of the property until it is all paid off.
Since the second mortgage would receive repayments only when the first mortgage has been paid off, the interest rate charged for the second mortgage tends to be higher and the amount borrowed will be lower than that of the first mortgage.
A second mortgage is also called a home equity loan.
- A second mortgage is a loan made in addition to the homeowner’s primary mortgage.
- HELOCs are often used as second mortgages.
- Homeowners might use a second mortgage to finance large purchases like college or a new vehicle.
How a Second Mortgage Works
When most people purchase a home or property, they take out a home loan from a lending institution that uses the property as collateral. This home loan is called a mortgage, or more specifically, a first mortgage.
The borrower is required to repay the loan in monthly installments made up of a portion of the principal amount and interest payments. Over time, as the homeowner makes good on his monthly payments, the value of the home also appreciates economically.
The difference between the current market value of the home and any remaining mortgage payments is called home equity.
A homeowner may decide to borrow against his home equity to fund other projects or expenditures. The loan he takes out against his home equity is known as a second mortgage, as he already has an outstanding first mortgage. The second mortgage is a lump sum of payment made out to the borrower at the beginning of the loan.
Like first mortgages, second mortgages must be repaid over a specified term at a fixed or variable interest rate, depending on the loan agreement signed with the lender. The loan must be paid off first before the borrower can take on another mortgage against his home equity.
Second mortgages are often riskier because the primary mortgage has priority and is paid first in the event of default.
Using a HELOC as a Second Mortgage
Some borrowers use a home equity line of credit (HELOC) as a second mortgage. A HELOC is a revolving line of credit that is guaranteed by the equity in the home. The HELOC account is structured like a credit card account in that you can only borrow up to a pre-determined amount and make monthly payments on the account depending on how much you currently owe on the loan.
As the balance of the loan increases, so will the payments. However, the interest rates on a HELOC and second mortgages, in general, are lower than interest rates on credit cards and unsecured debt.
Since the first or purchase mortgage is used as a loan for buying the property, many people use second mortgages as loans for large expenditures that may be very difficult to finance. For example, people may take on a second mortgage to fund a child’s college education or to purchase a new vehicle.
Second mortgages also can be a method to consolidate debt by using the money from the second mortgage to pay off other sources of outstanding debt, which may have carried even higher interest rates.
Because the second mortgage also uses the same property for collateral as the first mortgage, the original mortgage has priority on the collateral should the borrower default on his payments. If the loan goes into default, the first mortgage lender gets paid first before the second mortgage lender. This means that second mortgages are riskier for lenders who ask for a higher interest rate on these mortgages than on the original mortgage.
Second Mortgage Costs
Like the purchase mortgage, there are costs associated with taking out a second mortgage. These costs include appraisal fees, costs to run a credit check, and origination fees.
Although most second mortgage lenders state that they don’t charge closing costs, the borrower still must pay closing costs in some way as the cost is included in the total cost of taking out a second loan on a home.
Since a lender in a second position takes on more risk than one in the first position, not all lenders offer a second mortgage. Those that do take great steps to ensure that the borrower is good to make payments on the loan. When considering a borrower’s application for a home equity loan, the lender will check whether the property has significant equity in the first mortgage, high credit score, stable employment history, and low debt-to-income ratio.