Second mortgage guide: How does a second mortgage work?

October 25, 2022 - 12 min read

What is a second mortgage?

A second mortgage is a loan that lets you cash out the available equity in your home. Using it to tap equity won’t impact your existing home loan. Rather, it creates a separate loan secured by the property with its own rate and monthly payment. (That’s why they’re called “second” mortgages.)

Home equity loans and HELOCs are both second mortgages. When interest rates are high, most homeowners prefer one of these loans over a cash-out refinance. That’s because a second mortgage can withdraw equity without replacing your entire mortgage at a higher rate.

Find out if you qualify for a second mortgage. Start here

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How does a second mortgage work?

A second mortgage cashes out the equity built up in your home. It works by taking out a second loan (on top of your existing home loan) that’s secured by the home’s value. The amount you can borrow depends on how much equity you’ve accrued.

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You repay your second mortgage debt separately from your primary mortgage debt. So if you’re still paying off your initial home loan, you can expect to make two monthly payments: one toward your primary mortgage and another toward your home equity loan or HELOC.

As secured loans, second mortgages come with lower interest rates than other sources of cash, like credit cards or personal loans. You can use the money you withdraw for any purpose.

To qualify for this type of loan, you’ll need to have earned sufficient equity in your home. Most lenders want you to retain 15-20% equity in the property after your second mortgage is taken out — so you’ll need more than 20% equity to qualify in most cases.

You build equity as you pay down your mortgage loan and as your home’s value increases. Thanks to rising property values in the U.S., most homeowners are gaining equity at a much faster rate than they would just by paying down their home loans.

Types of second mortgages

There are two main types of second mortgages: a home equity loan and a home equity line of credit (HELOC). A home equity loan is a one-time, lump-sum loan with a fixed interest rate and repayment schedule, while a HELOC is a reusable credit line secured by your home’s value.

Find out if you qualify for a second mortgage. Start here

Home equity loan

A home equity loan allows you to withdraw a lump sum of cash from your home equity. That means you’ll receive a one-time payout upfront and start paying down the loan immediately. Your home’s value secures the loan.

Home equity loans work similarly to primary mortgage loans. You are charged a fixed rate of interest, you agree to a set repayment term (typically between five and 30 years), and you make monthly principal and interest payments each month after the loan closes.

Home equity line of credit (HELOC)

A home equity line of credit (HELOC) is a revolving credit line tied to your home’s value. Your HELOC credit limit depends on how much equity you’ve accrued. Once approved, you can borrow up to that limit, repay the loan, and borrow again — much like a credit card.

HELOC credit limits depend on your credit score and income as well as your home’s appraised value and your existing mortgage balance.

HELOCs typically charge variable interest rates based on the current prime rate. During the borrowing phase, you pay interest only on what you’ve borrowed from the credit line. During the repayment phase, you’ll pay back any outstanding balance on the loan. Since HELOC rates are variable, your payments can fluctuate over time.

You may also be able to convert your HELOC to a fully amortizing fixed-rate second mortgage during the loan’s term if your lender allows it. As with a home equity loan, your property serves as collateral to secure the financing.

What is a second mortgage used for?

Home equity loans and HELOCs can be used for pretty much any purpose. “There are usually no restrictions on how [the funds] can be used. Second mortgages are typically pursued for major expenses like home renovations, medical bills, or college tuition,” says Alex Shekhtman, CEO and founder of LBC Mortgage.

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Home improvements or renovations

Martin Orefice, CEO of Rent to Own Labs, says one of the best reasons to consider a second mortgage is to improve the value of your home.

“These loans borrow against the equity you have in your home, which is partially determined by the overall value of your property,” he explains. “If you use a home equity loan or HELOC to add value to your home through renovations, additions, or updates, you are getting a lot of your money back in the form of home equity — allowing you to borrow more money in the future or sell your home for more cash.”

Additionally, you could be eligible for a tax break if you use a home equity loan or HELOC for home improvements.

Debt consolidation

Second mortgages are a common tool to consolidate higher-interest debt. For example, if you have several high-interest credit card bills with payments in the thousands, it can make sense to pay these off in full using money from this type of mortgage. This results in one consolidated payment at a lower interest rate, which can lead to huge interest savings over time.

Buying a second home

Many homeowners use a second mortgage to make a down payment on a vacation home or investment property. Buying another property can be a great use for the equity in your current home since real estate often has a high return on investment.

Buying a primary home

It’s also possible to take out a second mortgage at the time you buy your house. “Piggyback loans" combine a larger first mortgage loan with a smaller second mortgage loan to help you purchase a home more affordably.

The second mortgage serves as a portion of your down payment. When you make a 10% cash down payment and take out a 10% second mortgage, you’re effectively putting 20% down. This can lead to lower interest rates and no private mortgage insurance (PMI).

Are there restrictions on how you can use a second mortgage?

Be aware that all lenders restrict the purchase of firearms and the right to gamble with proceeds from a second mortgage, according to Dennis Shirshikov, strategist with and professor of economics and finance for City University of New York.

“Some lenders won’t allow you to make certain investments with second mortgage funds either, like starting your own business,” he cautions.

If you have questions about how you can use your home equity, be sure to ask lenders about these potential restrictions at the time you apply. Each lender gets to set its own home equity loan and HELOC guidelines, so rules may vary from one company to the next.

Second mortgage pros and cons

If you own your home, a second mortgage is often the most affordable way to access extra money when you need it. It’s relatively easy to apply and get approved for a home equity loan or line of credit, assuming you meet the lender’s qualifications and have earned sufficient equity (usually at least 20%).

Find out if you qualify for a second mortgage. Start here

Second Mortgage ProsSecond Mortgage Cons
Low interest rates (vs. credit cards, personal loans) Often charges closing costs
May be able to borrow a large amount of cashCreates a second mortgage payment
Easy to applyDefaulting on the loan could lead to foreclosure

Second mortgage benefits

There are two main benefits of a second mortgage. First, you can often borrow a large amount of money at a low interest rate (depending on your personal finances). Second, a HELOC or home equity loan lets you cash out equity without refinancing your existing mortgage.

That’s a huge benefit when mortgage rates are rising, since most homeowners won’t want to refinance their current mortgage into a new loan with a higher balance and a higher rate.

Home equity loan benefits

The advantage of a home equity loan over a HELOC is that you’ll have a comparatively low fixed interest rate. Plus, you’ll have peace of mind knowing exactly what your principal and interest payments will be from month to month. You also have the option of making accelerated payments on the loan to pay it off more quickly, which can save you money on total interest.

HELOC benefits

Among the benefits of a HELOC, many lenders will permit you to borrow up to 85% of your home’s appraised value. Plus, with a HELOC, you can access a line of credit any time you need.

If you want to pay off your principal and interest during the draw period, you can do so. Similar to a credit card, your available credit is restored whenever you pay down your outstanding HELOC balance. So you can borrow against a HELOC again and again (up to your credit limit) over the length of the draw period.

Payments on a HELOC can be ultra-low, too. During the draw phase, you make only minimum interest payments on any money you choose to borrow. If you borrow no money, you typically owe nothing (although an inactivity fee may be charged).

Downsides of a second mortgage

On the downside, your home serves as collateral for a second mortgage. If you fail to make payments, your lender could foreclose on the property. Also, if your property value decreases, you could end up owing more on your home than it is worth — making it harder to sell.

That’s not all: You are also responsible for the loan balance if you sell your home. You will have to repay your home equity loan or HELOC in full when the home is sold, although you can typically use the proceeds from your home sale to pay off both the primary and second mortgage at the same time.

Lastly, home equity loans come with closing costs and fees that can range form 2% to 5% of the loan amount. HELOCs often charge fees at closing, too. Some lenders do offer no-closing-cost HELOCs, but these typically come with higher interest rates. So factor that into your long-term cost calculations.

Can I get a second mortgage?

You’ll need to demonstrate good creditworthiness to qualify for a second mortgage. “Aim for a credit score of 700 or higher and a debt-to-income ratio of 36% or lower to be eligible for lower interest rate and more preferred terms,” says Orefice. “You’ll also probably need at least 20% equity accrued in your home.”

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As with any form of financing, it’s wise to have your financials and paperwork in order before attempting to apply for a second mortgage. Gather recent pay stubs, bank and investment account statements, proof of employment, and the last two years of tax returns, as the lender will likely request these documents.

To learn more, see our guides to home equity loan requirements and home equity line of credit (HELOC) requirements.

Is a second mortgage a good idea?

If you have plenty of home equity, reliable income, and need to borrow a large sum of cash, a second mortgage is often the best way to do it. Thanks to the lower interest rates on second mortgages, you’ll typically pay much less in long-term interest than if you borrowed money using a personal loan or credit cards.

Find out if you qualify for a second mortgage. Start here

“Second mortgages are a relatively safe and sound way to borrow, provided your income is stable enough to support two mortgage payments for years to come,” adds Orefice. “They are an especially good way to maximize the value of your home and get access to more and better living space without having to go through the real estate market.”

That said, experts generally recommend tapping home equity only if your spending will have a good return on investment. Don’t use this type of mortgage to pay for a new car or expensive vacation.

“This type of mortgage is a good idea if you plan to use the money productively on debt consolidation or home renovations,” Shirshikov adds.

Depending on your circumstances and current interest rates, one alternative to consider is a cash-out refinance of your primary mortgage loan.

With a cash-out refi, you may qualify for a lower interest rate than a home equity loan or HELOC would charge. And you’d end up with one monthly loan payment instead of two separate loans to repay. However, you will incur closing costs and be resetting your loan. That means it could take longer to pay off your house and you might spend substantially more in long-term interest than you would otherwise.

Second mortgage FAQ

What does it mean to take a second mortgage?

Getting a second mortgage means you’re taking out another loan on top of your existing mortgage. The second mortgage is used to cash out some of your home equity. The cash can be used for any purpose. If you’re still paying off your original home loan, taking a second mortgage will create an additional monthly payment on top of your current mortgage payment.

How much can you borrow on a second mortgage?

You can typically borrow up to 80 or 85 percent of your home’s value when the first and second mortgages are combined. To find out how much you can borrow on a second mortgage, first estimate your home value. Then multiply it by 0.8 and subtract your existing loan balance. For example, if your home is worth $400,000 and you can borrow 80 percent in total, your maximum borrowing limit is $320,000. Say you owe $200,000 on your existing home loan. Subtract that from your maximum loan and you get $120,000. That’s the most you could likely borrow on a second mortgage.

What are the rules for a second mortgage?

A second mortgage usually requires you to have more than 20 percent equity built up in the home. You also need a credit score of at least 680-700 with most lenders, as well as a stable income and reliable employment. Lenders will check your financial documentation and order a home appraisal before approving the second mortgage, just as they did with your home purchase loan.

When is a good time to consider a second mortgage?

It’s smart to consider a second mortgage when you need a large amount of cash for a sound investment, like making home improvements or buying a rental property. Homeowners often turn to second mortgages when interest rates are high and they don’t want to take a cash-out refinance (which would raise the rate on their current mortgage).

Is it hard to get a second mortgage?

The second mortgage process works a lot like the standard mortgage process. You can expect to provide most of the same application documents that you did when you bought your home. Thanks to rising property values nationwide, many homeowners have gained a substantial amount of equity and can easily qualify for a second mortgage.

Your next steps

If you think a second mortgage is right for you, connect with a lender to explore your options. “You can apply for a home equity loan or HELOC through local or online lenders,” says Shirshikov. “Shop around carefully and compare loan offers from several different lenders.”

Keep in mind that each lender gets to set its own requirements and rates for second mortgages. So options and pricing can look very different from one company to the next. Shopping around will help you maximize your cash-back and minimize your costs.

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Erik J. Martin
Authored By: Erik J. Martin
The Mortgage Reports contributor
Erik J. Martin has written on real estate, business, tech and other topics for Reader's Digest, AARP The Magazine, and The Chicago Tribune.