What Is a Second Mortgage and How Does It Work?

A second mortgage lets you borrow against the equity you’ve built in your home without affecting your primary mortgage. You can use the money for a wide range of purposes, from consolidating debt to funding home renovations to treating your family to an epic vacation.

However, your home serves as collateral for these loans. Keeping up with repayment for your second mortgage is just as important as staying on top of payments for your primary mortgage. Understanding how a second mortgage works is key to knowing the risks, using the funds responsibly, and protecting one of your greatest financial assets: your home.

What is a second mortgage?

A second mortgage is a type of secured loan for which your home serves as collateral. You borrow against the home equity you’ve built. These loans typically have lower interest rates than personal loans and credit cards because they're secured by your home.

However, that's also where the risk comes in: If you fall behind on payments, the lender could foreclose on your home.

How does a second mortgage work?

There are two major types of second mortgages: home equity loans and home equity lines of credit (HELOCs). While these two loans work differently, they’re both based on the equity you’ve built in your home.

To calculate your equity, take the current value of your home and subtract what you still owe on the mortgage. That number is your equity. For example, assume:

• Home value: $400,000
• Mortgage balance: $250,000
• Your equity: $400,000 - $250,000 = $150,000, or about 37% equity.

In this scenario, you have $150,000 of equity, but it’s tied up in your home. That is, you can’t spend that money, even though you theoretically have it. In other words, it’s not liquid. That’s where second mortgages come in.

Typically, lenders don’t let you access the full equity you have in your home. Instead, they generally allow a maximum combined loan-to-value ratio (CLTV) of 80% to 90%, but requirements vary by lender. That means your total debts — your primary mortgage and the second mortgage, combined — can’t exceed 80% to 90% of your home’s value.

For instance, in the scenario above, your home is worth $400,000. Assume a lender allows a max CLTV of 85%, or $340,000, but you still owe $250,000 on your mortgage. To determine how much you can borrow with a second mortgage, subtract what you still owe from $340,000. The result — $90,000 — would be the max amount you could borrow.

What can you use a second mortgage for?

You can use a second mortgage to cover many kind of expenses, but here are some of the most common use cases:

Debt consolidation

Because home equity loans and HELOCs generally have lower interest rates than credit cards, they can be especially useful for paying down high-interest debt. They can also be useful for reducing monthly payments. Rather than making multiple loan payments each month, you would instead consolidate the debts into one monthly second mortgage payment, ideally with rate low enough to save you money on interest.

Home improvement

Using home equity funds to remodel or repair your home is a smart idea. Ideally, the home renovations — building an addition, remodeling a kitchen, upgrading the roof, etc. — can increase your home’s value. That means you could sell your home for money, making it easier to pay off the second mortgage. Plus, the interest paid on money used to finance home improvements may be tax-deductible if used to improve your primary residence.

College costs

You could use a second mortgage to supplement your child's student loans. Lenders typically don't allow you to use personal loans for secondary education expenses, but home equity loans and HELOCs tend to be more flexible.

Given the risks involved with second mortgages (your house secures the loan), carefully consider whether the loan is justified. 

“The biggest mistake I see is treating home equity like free money,” says Andrew Gardner, founder of LEAP Properties. “If you’re using [a second mortgage] to solve a short-term cash flow problem or pay off credit cards without changing your spending habits, you’ve just moved unsecured debt onto your house. That’s a much bigger risk than most people appreciate.”

What are the types of second mortgages?

Although the main types of second mortgages are home equity loans and HELOCs, you may also hear the term “piggyback” second mortgage. This strategy typically involves taking out a home equity loan or HELOC at the same time as your primary mortgage. It's often used as a method of getting additional funds to increase the down payment, avoiding the need for private mortgage insurance.

Home equity loans

A home equity loan is a traditional installment loan. You’ll receive one lump sum at the start of the loan, then make monthly payments for a set number of years until you’ve paid back what you borrowed, plus interest.

Home equity loans typically have a fixed interest rate and fixed repayment term (usually between five and 20 years), so your monthly payment remains the same throughout the life of the loan.

A home equity loan could be the right choice if you know exactly how much money you need and don’t anticipate needing to borrow more.

HELOCs

A home equity line of credit is a form of revolving credit, allowing you to tap into funds on an ongoing basis and only pay interest on the amount you borrow.

There’s typically a fixed draw period (usually five to 10 years) during which you can borrow money as needed and make interest-only payments. Then during the repayment period (often 10 to 20 years), you’ll pay back what you borrowed plus interest.

“A HELOC acts as a piggy bank for a borrower, meaning that as they pay down [the] principal, they can borrow the funds again during the introductory interest-only period,” says Sarah DeFlorio, vice president of mortgage banking at William Raveis Mortgage.

HELOC interest rates are usually variable, meaning the total cost of borrowing and your monthly payment can change.

HELOCs make sense for ongoing home renovations. You can draw what you need when tackling one project, pay back what you can, and then borrow again for another home improvement.

How to get a second mortgage

Second mortgage requirements vary by lender, but you’ll often need to meet criteria such as:

• Home equity: Lenders typically want you to have at least 15% to 20% equity in your home. That typically means you’ve paid off 15% to 20% or more of your mortgage. A home appraisal is often part of the application process for a second mortgage to establish your home's current value.
• Credit score: Some lenders may approve you for a home equity loan or line of credit with a score as low as 620, but others have more stringent standards (like 660 or even higher). Having the bare-minimum credit score may get you in the door, but you’ll pay much higher rates than you would with a score in the 700s or above.
• Debt-to-income ratio: Lenders may compare your monthly debt obligations against your monthly income. Typically, a debt-to-income ratio (DTI) 43% is preferred for mortgage lending.

To get a second mortgage, you can apply with your current mortgage lender or research other lenders whose requirements you meet and that offer the best rates and terms.

If you choose another lender, keep in mind that you would also have another lien on your home, sometimes called a junior lien. The presence of a second lien could make the question of ownership less clear and complicate the process of selling or refinancing. 

Pros and cons of a second mortgage

Second mortgages offer some obvious benefits, but weigh them against the drawbacks before moving forward.

Details on the pros

• May have lower interest rates than other loans: Generally, home equity loans and HELOCs have lower interest rates than credit cards and personal loans.
• Long repayment terms: Home equity loans and HELOCs may offer repayment terms significantly longer than personal loan repayment terms. This often means lower monthly payments.
• Can increase your borrowing power: Depending on your home's value and how much equity you have, available loan amounts could exceed $100,000. Some second mortgage lenders cap loan amounts at $500,000. 
• Potential tax deductions: If you use the funds to substantially improve your primary residence or second home, or to build or buy another home, interest may be tax-deductible.

Details on the cons

• Risk of foreclosure: The biggest risk of a home equity loan or HELOC is that your home serves as collateral. If you can’t keep up with payments, the bank could foreclose on your home.
• Increased debt: Taking on more debt can be a gamble. Instead of just one monthly mortgage payment, you’ll have to budget for two monthly mortgage payments.
• Risk of decreasing home value: While we typically expect home values to increase over time, that’s not always the case. If your home value drops, you could end up owing more on the primary and second mortgages than you’d get if you sold the house.
• May be hard to qualify for: If you don't have at least 15% to 20% home equity — along with good credit, stable income, and manageable current debt — you'll likely have trouble qualifying. 
• Closing costs: As with a primary mortgage, a second mortgage typically involves closing costs ranging from 2% to 5%.

Second mortgage vs. a cash-out refinance

Second mortgages aren’t the only way to tap into your home’s equity. You could also consider a cash-out refinance.

Unlike a traditional refinance, where the goal is often to get a more favorable interest rate or longer loan term to lower monthly payments, the primary goal of a cash-out refinance is to replace your current mortgage with a mortgage that is larger than you currently owe. The new mortgage will pay off the old mortgage, and you’ll receive the remaining money.

Rather than have a primary mortgage and second mortgage to repay, you’ll instead just have a single mortgage with a cash-out refi. However, the clock starts over for repayment. You’ll also likely pay closing costs for a refinance, which are typically higher than the origination fees associated with a home equity loan or line of credit.

So how do you know if a second mortgage or cash-out refi is right for you?

“You have to look at the blended average of rates when considering a HELOC vs. a cash-out refi,” says DeFlorio. “For example, you may be protecting a great first-rate mortgage, but when you consider how much higher HELOC rates are, there are times when your monthly payment would be better just doing a traditional cash-out refi.”

Ultimately, it pays to sit down and do the math with a financial advisor to determine which one will cost you more in interest in the long run. You should also calculate the overall monthly payment (or payments) you’ll be responsible for in every scenario, if lowering your monthly payment is a priority.