Second mortgage funding: The definitive guide

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Taking equity from your home is now becoming one of the most common ways to access funding for big purchases or investments. If you’ve never applied for a second mortgage, this comprehensive guide is for you.

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What is a second mortgage?

A second mortgage is a type of loan that you can take out against your home equity. Home equity is essentially the amount of your home that you actually own.

For example, if you bought a home worth $300,000 and paid a 20% downpayment of $60,000, the total home equity you’ll have as soon as you close is $60,000. As you continue to pay your monthly mortgage, you’ll continue to build up your home equity.

Most lenders can let you borrow around 80-85% of your home equity, and you can use the funds from the second mortgage for any purpose. Most people use second mortgage loans to consolidate debts, finance home improvements and repairs, or afford other big expenses or purchases.

How does a second mortgage work?

Your first mortgage is the primary loan you take out to buy a particular property. The second mortgage, on the other hand, is the additional loan taken out on the same property. In case you’re unable to repay the loan and your property is foreclosed, the proceeds from the foreclosure sale will be distributed among the lenders according to this specific hierarchy. The first mortgage claims priority over subsequent creditors. The remaining funds will go to the other second or junior mortgages.

For example, if the amount collected from the foreclosure sale is $250,000 and you still owe your first mortgage lender $200,000, the first mortgage can claim the full amount of $200,000. If you owe $60,000 for your second mortgage loan, there’s only $50,000 left from the foreclosure proceeds, and it will then be $10,000 short. Due to the added risk to the second mortgage lender, their interest rates are usually higher than first mortgage rates.

Who is eligible for a second mortgage?

The eligibility requirements for second mortgages usually vary depending on the type of loan and the lender. However, you can usually qualify if you meet the requirements below:

Equity-:you already have 15-20% equity in your home
Credit: You should have a good credit score, typically around 600
Income: You should provide proof of a steady income source that shows your capacity to afford the monthly payments
Debt: You shouldn’t have too many pending debt obligations. You debt-to-income ratio should be below 43%
Money for extra fees: There are upfront fees you need to cover including appraisal fees and closing costs
Documentation: Lenders will give you a list of documents to secure such as your bank statements, tax returns, pay stubs, etc.

Why should I take out a second mortgage loan?

It can be tempting to get a second mortgage considering the high lump sum of money with some lenders offering up to 90% or even 100% of the home equity. You can use the money from a second mortgage for any purpose, but some good reasons to take out a second mortgage include:

You’re looking to buy a rental property– If you need more funds for the down payment of a prospective rental property, a second mortgage can help you achieve the liquidity you need.
You need to cover high education costs– College is expensive, which may put some families in a tough spot. A home equity loan can help you pay tuition and other education costs.
Home improvement– Home improvements are a great way to enhance the comfort and curb appeal of your home while also increasing its value. However, they can be very expensive, making second mortgages a great option to make your dream renovation possible.
You need money for medical debt and expenses- You can use the money acquired from a second mortgage for whatever purpose. If you or your family encounter health issues and need more funding to cover for medical expenses, a second mortgage can be a good option.
You want to consolidate loans– Mortgage loans generally offer cheaper interest rates than other forms of credit. Many people choose to consolidate debt and replace high-interest loans with a second mortgage.

If you decide to take out a second mortgage, two main options include home equity loan (HELOAN) and home equity line of credit (HELOC). They both use your home as collateral and have lower interest rates than credit cards or personal loans. Here are the key differences between the two:

HELOAN– It’s a one-time transaction, and you receive the amount in a lump sum. If you need to get more funds, you need to take out another loan. The interest rates for home equity loans are fixed, making the monthly payments consistent over the term of the loan.
HELOC– Like credit cards, HELOC comes with credit limits. A ‘draw period’ is set which could last between five and ten years. You can keep on borrowing during this period, and when the draw period ends, you can no longer borrow from your HELOC and the ‘repayment period’ starts. You can repay the full balance over a 10 or 20-year period, depending on the lender. HELOCs also have a variable interest rate, so the payments may change from month to month- although some HELOCs allow you to convert some of your balance from variable to fixed-interest rate.

What should I consider before getting a second mortgage?

To set the right expectations, consider the following before you apply for a second mortgage:

Higher fees and charges

Since second mortgages are inferior to the primary mortgage in the event of loan default, they need to make up for the extra risk. Although a second mortgage essentially has the same function as the first mortgage, they are likely to come with higher processing fees and interest rates than the first home loan. There also could be other charges involved like settlement costs, origination fees, appraisals, title fees, etc.

Fees from your primary lender

One home loan already brings a degree of financial stress to families– paying for two simultaneously would be like fighting a war on two fronts. Before taking out a second mortgage, evaluate your financial situation thoroughly and make sure you’re able to afford the additional monthly payments without having to compromise on other important expenses.

Budgetary considerations

The conventional rule of thumb is that no more than 28% of your monthly gross income should go to your mortgage payments. Holding two mortgages can make your finances even trickier, so it’s a decision that you should make carefully.

The following are some of the questions you should ask yourself before taking out a second mortgage:

Can I manage the additional monthly payments if I experience financial setbacks like sudden unemployment?
Am I currently living beyond my means? What other debts do I have?
Are my planned home improvements building the resale value of my home? Is the purpose of my loan well-considered?
Am I ready for the costs involved such as closing fees, home appraisal, state taxes, and annual fees?
What type of repayment schedule should I consider?

The thing is, home equity loans can be a valuable tool for responsible borrowers. Home equity loans generally have lower interest rates than personal loans or credit cards. As long as you have a reliable source of income to repay the loan and you’re using the second mortgage the right way, it can be a sensible alternative to acquire funding.

Tougher lending criteria

One of the main requirements to get a second mortgage is having sufficient home equity. You should own at least 15 or 20% of your home before you can apply for a second mortgage. On top of that, you may not meet the lending criteria if you have:

Poor credit score– Lenders will analyze your credit history, and if your credit score is low such as below 620, you may not be able to qualify. However, you can try shopping around to find lenders who can work with borrowers with lower credit scores. You can also actively work on building your credit standing by paying down your credit card balances, fixing any errors on your credit report, or paying bills on time.
Unstable employment or income– If your income stream is rather unstable or you have a history of switching jobs frequently, these could be warning signs in the eyes of potential lenders. To manage risks better, they prefer borrowers who have a more stable income and employment.
High debt levels– Financial institutions will also check your DTI or debt-to-income ratio. You shouldn’t have too many outstanding debts and financial obligations to fulfill. If you do, perhaps you can pay down some of your existing debts first before applying for a second mortgage to lower your DTI ratio to around 43% or lower.

Buying an investment property

If you want to buy a rental or investment property, you can use the money acquired from the second mortgage for your down payment. Take note that there are certain nuances when it comes to buying investment properties. For example, your investment property is not allowed to be your primary residence. For tax purposes, you also can’t use it for personal purposes for more than 14 days a year or for more than 10% of the time the property is rented out per year. The interest rates for investment properties are also a bit higher than loans on primary residences or second homes/vacation homes.

As long as you use second mortgages strategically to acquire investment properties, it can become a lucrative and sustainable venture. For example, you can buy foreclosed homes at rock-bottom prices, engage in house flipping, or perhaps just invest in REITs to own fractional shares of multiple properties.

Is it easy to get a second mortgage?

Since the requirements could be more strict in terms of credit score and debt-to-income ratio, second mortgages can be more difficult to acquire than first mortgages. The approval time also varies. You first need to have your property appraised, and it typically takes weeks for the lender’s underwriter to review your application. Another potential barrier is the associated costs in terms of appraisal fees, origination fees, closing costs, etc.

How much can I borrow with a second mortgage?

A second mortgage can really help you achieve liquidity to afford big purchases or investments. Although you can’t borrow the full amount, you can obtain between 80% and 90% of your home equity, depending on the lender. There are even some who can offer up to 100% of your home’s value, but the majority is capped at 85%.

For example, if your property appraises for $500,000 and you owe $300,000 on your first mortgage, the home equity you’ve built up is $200,000. This is the amount you can borrow against for your second mortgage. If your second mortgage loan is capped at 85% of your home’s equity, you can borrow an additional $170,000 in a second mortgage.

What are the pros and cons of a second mortgage?

Second mortgages are a common way to access a lump sum of cash in just a short amount of time. However, before you jump in, make sure to weigh the pros and cons:

Pros of second mortgage

High loan amounts
How you use the money is up to you
Payment arrangements can be flexible
Lower interest rates than unsecured loans or credit cards

Cons of second mortgage

Strict qualification criteria
Comes with additional costs and fees
Interest rate is higher than first mortgage
Risk of repossession if you fail to keep up with repayments

How to apply for a second mortgage

To apply for a second mortgage, you need to consider and prepare for the following:

Make sure you own 15-20% equity in your property
Achieve a minimum credit score (usually mid to high 600s range)
Meet acceptable levels of debt-to-income ratio (typically below 43%)
Gather financial documents including tax returns, bank statement, and other documents that demonstrate your financial stability
Consider a joint application with your partner or spouse to increase combined income and improve your affordability
Be prepared for the valuation process as lenders require it before approving a second mortgage

How is a second mortgage loan different from a primary one?

The first mortgage is the first loan you have taken out on a property. The succeeding ones are considered your second or subordinate mortgages. If you are not able to fulfill your monthly repayment obligations on your loan, this leads to a loan default and your property will be subject to foreclosure.

Once it’s foreclosed and sold, the proceeds from the sale will be distributed among creditors. The primary or first mortgage will claim priority over the funds from the foreclosure sale. The remaining amount can be claimed by the second mortgage lenders. The remainder may not be enough to pay back the second mortgage balance, making second mortgages riskier for lenders than primary mortgages, thus the higher interest rates and stricter qualification criteria.

Can I get a second mortgage if I have bad credit?

You may not be eligible for a second mortgage if your credit score is low, such as in the 500s range. Typically, the minimum credit score is 620 or higher. However, if your debt-to-income ratio is low and your income is high and steady, you may still be able to qualify despite your credit history. Loan approval for borrowers with poor credit score is on a case-to-case basis, depending on the full scope and the lender’s appetite for risk.

What are some alternatives to a second mortgage?

Although a second mortgage is a great way to acquire a large sum of money fast, it’s not the only option. There are other alternatives you can consider, especially if you don’t qualify for a second mortgage. These include:

Personal loan– This is one of the main alternatives to second mortgages. It’s typically unsecured, so there’s no collateral involved. The interest rate and repayment period are fixed, and the processing and approval process is also easier and faster.
Cash-out refinance– This is another way to tap your home equity and use your home as collateral for your new loan. You’re essentially replacing your current mortgage with a bigger loan and receive the difference in cash.
Unsecured personal lines of credit– Although unsecured lines of credit may be tougher to get for both individuals and businesses, it’s a great alternative since your assets won’t be subject to seizure upon default. This is like a personal loan, but lines of credit can be used multiple times for as long as you make your payments on time. It’s similar to credit cards with ‘credit limits’ and the limits are reset when the loan is repaid.
Credit cards– Lines of credit and credit cards are similar but differ in terms of how you access the money. Lines of credit usually offer checks, bank transfers, or a card. Credit cards can be used just by tapping, dipping, or swiping. In terms of interest rates, lines of credit may come lower, but both require payment of annual fees.

Is it better to refinance or take out a second mortgage?

Both of these options allow you to use the money however you want. However, with a second mortgage, you’re getting an additional loan to your primary mortgage. With refinancing, you’re replacing your first mortgage and getting a single, larger one. You may also change your loan’s rate and terms as you switch to refinancing. If you’re trying to consolidate debt or pay for a large expense, cash-out refinance could be a good option. However, if you don’t want to change your mortgage terms and don’t know how much money you need, you may just go for HELOC or second mortgage to access funding.

How Swoop can help

Shop around conveniently and instantly find the best lender for your needs. Here at Swoop, we can help you access funding for your personal or business requirements.

Just answer a few questions, so we can find the perfect match for you. If you can’t qualify for a second mortgage, explore other financing options we have in store for you.

Apply for funding today!