If you’ve ever purchased or even considered purchasing real estate, you’ve probably heard the term second mortgage. But what is a second mortgage? Luckily, the term is fairly self-explanatory.
In its simplest terms, a second mortgage is a mortgage that is borrowed against a property with an existing mortgage loan. A second mortgage is considered a subordinate mortgage, secondary to the first mortgage. This means that any payments you make go to paying off the initial mortgage first. Only after that mortgage is paid off does the lender of the second mortgage start receiving payments.
A second mortgage functions differently from a first mortgage, and is usually used for a different purpose. Second mortgages are useful tools for consolidating debt, and they can provide a source of emergency cash during periods of financial hardship. Taking out a second mortgage carries some inherent risk, and should usually be considered only as a last resort — if you anticipate defaulting on your primary mortgage, for example.
How Does a Second Mortgage Work?
To understand how second mortgages work, it’s important to understand the function of mortgages in general. When you think of a mortgage, you’re probably thinking a structure similar to a traditional mortgage from a bank. These types of loans are usually called prime mortgages. To get a prime mortgage, you’ll need to book an appointment with a mortgage advisor at a bank, and be prepared to undergo a mortgage stress test — a federally-regulated evaluation of your finances, and your ability to continue making regular mortgage payments even at a higher interest rate or in a worst-case economic scenario.
Prime mortgages are usually long-term loans — the exact amount of time can vary widely, but a lot of mortgages are paid off over a term of 25 years or longer. Prime mortgages also offer interest rates that are comparatively low, especially if you have an excellent credit rating and can prove that you have stable income. A prime mortgage is designed to cover the cost of the initial purchase of a house. When such a mortgage starts, the lender essentially purchases the home, minus the amount of your down payment, and the money that you pay back each month goes back to the lender.
With a second mortgage, there are key differences in these areas.
Length of the Mortgage Term
A second mortgage is usually a shorter loan than a prime mortgage. Most second mortgages last for periods of 5 years or less. This is because they are designed to bridge the gap during financial hardship, rather than cover the cost of a home purchase outright, like in the case of a prime mortgage.
If you take out a second mortgage in the form of a home equity line of credit (HELOC), then it will likely last longer due to the revolving nature of a HELOC.
Banks charge interest to help mitigate the risk of lending a large sum of money to someone. Interest is, essentially, what you pay for the privilege of borrowing money in the first place. It lets lenders recoup base costs faster, and allows them to earn money on their investment, which in turn gives them more investing power.
Second mortgages are inherently riskier than first mortgages. Part of this is inherent to the nature of the loan — if you’re taking out a second mortgage, it means you’re already in a position of financial need, which makes you a less reliable borrower. It doesn’t make you a bad person, but if you are struggling financially then you will most likely take longer to pay back a loan, or be more likely to default.
The second reason is the nature of the lender. Banks rarely, if ever, lend second mortgages — these types of loans are the domain of “B lenders” like trust companies and credit unions, as well as independent and private lenders. These lenders, particularly private lenders, will lend to those with credit scores too low to be approved by banks, and can do so by charging higher interest in order to mitigate the risk that comes with the territory.
These factors mean that interest rates for second mortgages tend to be significantly higher than even the most subprime of bank mortgages.
A second mortgage is borrowed against the same collateral as a first mortgage, however, since the first mortgage was already used to pay off the price of the home, the sum of money from a second mortgage can be put toward whatever you need it for. There are a wide variety of possible uses for a second mortgage loan, including:
- Consolidating debts, such as those from an existing mortgage, student loans, and credit cards
- Covering emergency expenses such as flooding or fire damage
- Continuing to meet mortgage payments in the event of a layoff or economic downturn
- Covering one-time expenses related to opening a business
Is a Home Equity Loan the Same as a Second Mortgage?
Effectively, yes, because a home equity loan is a very general term used to describe any loan that uses the value of your home as collateral. This describes both second mortgages and prime mortgages.
Sometimes the umbrella term “home equity loan” is used to describe a HELOC, but these are not the same thing.
A HELOC is a revolving loan. What this means is that when you pay back money, that amount becomes available for you to use again. A HELOC, or any line of credit for that matter, functions similarly to a credit card, though usually with much lower interest rates.
A second mortgage, on the other hand, is usually a lump-sum loan. You receive the entirety of the loan up-front, and any portion that you pay back goes to the lender.
Is it Easy to Get a Second Mortgage?
Getting a second mortgage shouldn’t be difficult, provided you meet certain criteria. Second mortgages are usually lent by private or alternative lenders. Because these types of lenders aren’t required to follow the same standards as banks, they won’t pay as much attention to your credit rating.
When applying for a second mortgage, you’ll need to consider your financial status, and the value of your property.
Most private lenders will look for a no more than 80 percent. This means that your existing mortgage may only cover up to 80 percent of the home’s value, with 20 percent left over as equity. If, when you took out your first mortgage, your down payment was less than 20 percent, then you will not be able to take out a second mortgage until you have paid enough of your initial mortgage to cover the difference, at minimum.
Second mortgage lenders will also look at the overall market value of the property, and your financial status. If you are unemployed or otherwise have no income, it is unlikely that you will be approved even by a private lender. Likewise, if the property you’ve mortgaged would have a very low resale value, the lender may not approve you because there is a risk that they would not be able to recoup their costs even by invoking power of sale.
Working with an independent mortgage broker can be a great option in this case. A broker can act as a middleman between you and different lenders, helping you find an investor who can offer a mortgage loan to suit your financial needs.