If you own a home and you’re looking to access some of your equity to consolidate debt or make some purchases, you can do so in various ways. One way to free up your capital is with a second mortgage. However, before you apply, you must understand how they work.
What is a second mortgage?
A second mortgage is an additional home loan that you get from a different lender on a property that already has a mortgage. As the homeowner, you’ll be making payments on both your second and primary mortgages simultaneously.
When unlocking the equity in your home with a second mortgage, you can’t access more than 80% of the property’s value. For example, let’s say your home has a current market value of $500,000, and you still owe $300,000 on your first mortgage. That means your second mortgage could not exceed $100,000.
For reference, the formula looks like this:
Current market value X 0.80 – remaining mortgage balance = Second mortgage limit
Using the example above, here’s how the numbers look.
$500,000 X 0.80 = $400,000
$400,000 – $300,000 = $100,000
It’s worth noting that most major financial institutions don’t offer second mortgages. If you’re still interested in one, you’d have to go to a private lender or consult with a mortgage broker.
Fees and interest rates on second mortgages
When getting a second mortgage, you’re adding another lender to the title of the property, so there will be additional fees that you need to consider, including:
- Administration fees
- Appraisal fees
- Title search
- Title insurance
- Legal fees
In addition, the interest rate charged on second mortgages will likely be higher than on your first mortgage because the additional mortgage lender takes the second position on the property’s title. If you were to default, and your home is sold, the original lender gets paid first. In other words, the second lender takes on additional risk, which is why they charge you a premium.
How to qualify for a second mortgage
Since a second mortgage is another loan, you’ll need to qualify before you are approved. The following information is what lenders will consider.
- Equity built. You’ll need to provide your primary mortgage details so the second mortgage lender can see how much equity you have.
- Income verification. Lenders will want to see that you have steady employment — this could be in the form of a letter of employment or recent pay stubs.
- Credit score. Lenders will check your credit history during the qualification process. The higher your credit score, the better.
- Property value. You will need an appraisal to determine the current property value.
Pros and cons of a second mortgage
Second mortgages are no different from any other consumer product out there. You need to do your research and consider the advantages and disadvantages before you apply.
Pros of a second mortgage
- You may qualify even with bad credit.
- The equity unlocked can be used for anything, including debt repayment, home renovations and unexpected expenses.
- You can access up to 80% of your appraised home value.
Cons of a second mortgage
- You’ll be paying higher interest rates compared to your primary mortgage.
- More expensive than other options.
- A second mortgage puts you one step closer to defaulting since you now owe two lenders.
Alternatives to a second mortgage
Second mortgages are expensive, but they might be right for you if you have a weak credit score and don’t qualify for any of the following options.
» MORE: How to check your credit score
Home equity line of credit
A home equity line of credit (HELOC) is typically the cheapest option when you want to unlock your home’s equity. A HELOC is a revolving line of credit secured by your home, so you get a lower interest rate. You can access up to 65% of your home’s value with a HELOC, but you also need to factor in your outstanding mortgage loan. The combination of the two can’t exceed 80% of your home’s current market value.
A blended mortgage is a popular option for homeowners who have seen interest rates fall below what they’re currently paying. By getting a blended mortgage, you can access the equity in your home and/or get a lower interest rate. The rate you get would fall between your existing mortgage rate and current rates. Hence the term blended. Since you’re technically keeping your mortgage, you avoid prepayment fees.
Although expensive, second mortgages can still be cheaper than other consumer credit products such as credit cards, auto loans, and even unsecured lines of credit. Ideally, you should only use a second mortgage for debt consolidation if no other options are available.