How does a second mortgage work?
Most homeowners pay for their homes by taking out a mortgage, which they repay by making payments over time. Loan payments that are made toward the mortgage principal build up equity in your home, increasing the percentage of the home that you actually own.
You can use that equity as collateral to take out another loan known as a second mortgage, allowing you to pay for major expenses such as home remodeling. Home equity lines of credit and home equity loans are two common types of second mortgage.
Second mortgages are a popular method of refinancing your original mortgage, but you’ll need to consider various factors before choosing a lender.
Overview
The amount of a second mortgage for which you will qualify depends on factors such as your equity, income and credit score. Individual lenders will also determine their borrowing limits by considering your debt-to-income (DTI) ratio and the loan-to-value (LTV) ratio of your home.
DTI is the ratio of your total debts to your total income, which is calculated by dividing what you owe by what you make. This value indicates your ability to repay a loan, and most lenders consider a DTI of less than 40% to be favorable for a second mortgage.
An LTV ratio is the ratio of the amount of the loan to the amount of the equity you have in your home. In the case of a second mortgage, the LTV is the value of your loan divided by the value of your equity. Lenders typically set the maximum amount they’re willing to lend on a second mortgage as a percentage of your equity, usually 80%. Assume for this example that the fair market value of your house is $350K and you still owe $150K on it, which means that your equity is $200K ($350K - $150K). A lender that sets a maximum LTV of 80% would thus be willing to lend you ($200K x 0.80) = $160K for your second mortgage.
In addition to equity and debt limits, lenders may also place an overall maximum limit on the amount of the loan. Many lenders also require their loans to conform to guidelines from government agencies such as the Federal Housing Finance Agency (FHFA).
Cost
As with any loan, the principal and interest are the primary costs of a secondary mortgage. However, second mortgages do incur additional costs that can vary greatly depending on the lender. Some of these fees are fixed amounts, while others are a percentage of the loan. These fees can run into thousands of dollars for some lenders, so it’s important that the loan be large enough and the savings in interest costs great enough to justify these costs.
The closing costs on a second mortgage can include the following:
Origination fees
Credit check fees
Appraisal costs
Mortgage insurance
Origination fees are what you pay the lender to process you application, technically known as originating the loan. These include application fees, processing fees and underwriting fees.
Some lenders also charge a fee for pulling your credit report, commonly known as a hard inquiry. A soft pull is just a check of your credit score that many lenders perform when pre-qualifying your application, and shouldn’t incur a cost to you.
Lenders need to know what your house is worth before they can approve your loan. Many lenders simply do a drive-by appraisal, which is just a quick check to ensure that your house is similar to other houses of a certain value in that neighborhood, or rely on automated valuation models. Other lenders, especially banks, require a formal appraisal from a professional appraiser, the cost of which would be included in your loan.
Lenders generally require, or at least prefer, that your equity be above a certain percentage of your home’s value, typically 20%. If it’s below this preferred level, you’re likely to need mortgage insurance to protect the lender in the event you default on your payments. The premiums will be included in your payments if your loan requires mortgage insurance.
Cash-out refinancing
Cash-out refinancing is a way to refinance an existing mortgage without taking out a second mortgage. This method involves taking out a new mortgage that replaces the first mortgage. The new mortgage is for a larger amount than the existing mortgage, and you receive the difference in cash. Essentially, cash-out refinancing allows you to turn some of your equity into cash. Sensible uses of this cash include making improvements to your home, consolidating high-interest debt and starting a business.
Assume, for example, that you have $200K in equity on a house worth $350K, meaning you still owe $150K. You could do a cash-out refinancing for $180K, which is $30K more than you owe on the first mortgage. In this case, you would receive a check for $30K minus closing costs.
Summary
Lenders differ considerably in how long they take to process and service loans, even in cases where their interest rates are quite comparable. The time between when you apply for a loan to the time the lender closes on the loan is one of the biggest differences among lenders.
Traditional lenders take an average of 39 days to close on a cash-out refinancing, and 2-6 weeks to close on a HELOC on home equity loan.
A second mortgage can save money when it results in a lower interest rate, assuming closing costs are less than the savings in reduced interest.
It's important to balance what you need with how fast you need it.
