What You Need to Know About a Second Mortgage

House sitting on pile of dollar bills
Getty ImagesIf you're thinking about taking out a second mortgage, here's what you should consider.

By Geoff Williams

If you don't know what a second mortgage is, or only have a vague understanding, there's probably a good reason. You likely don't want to know. After all, paying for a first mortgage can be bad enough. Hearing the term "second mortgage" is enough to make anyone's eyes glaze over.

But it's a financial strategy that's helped many a homeowner. So if you've ever wondered what you need to know about a second mortgage, consider this your crash course.

What it is. It's a second mortgage on your existing home. (Yes, theoretically, if someone refers to a second mortgage, they could be talking about another mortgage on house No. 2, like a cottage at the lake. Lucky them.)

If you take out a second mortgage on your home, you're borrowing money using your house's equity as collateral.

There are two types of second mortgages: a home equity loan, which usually lasts 15 to 30 years, just like your first mortgage, and a home equity line of credit, which allows homeowners to use a line of credit based on their home's equity. But those 15- and 30-year second mortgages are becoming very rare.

%VIRTUAL-WSSCourseInline-750%You'll most likely take out a home equity line of credit, says Heather McRae, a senior loan officer at Chicago Financial Services, a mortgage lender in Chicago.

"Those two terms, 'home equity line of credit' and 'home equity loan,' are used interchangeably," she says. "Obtaining a second mortgage as a fixed-rate, closed-ended loan is difficult to find these days. What I mean by closed-ended is that it functions like an installment loan rather than a credit card."

An auto loan is a good example of a closed-end loan, McRae adds. "If you pay according to the schedule, the car is paid off within a defined period of time," she says. "Home equity loans do not function like this, per se."

"Most home equity loans have a 30-year amortization period but are interest only for the first 10 years, which means the minimum payment required is just the interest," McRae continues. "You can pay extra to pay down the balance, and you can run the balance up again just like a credit card. After 10 years go by, the existing loan balance is amortized over a 20-year period, and it turns into a closed-ended loan. No more running up the balance if you need access to cash."

Why people take on second mortgages. Well, they need money, and they need a lot of it.

"The primary advantage of a second mortgage is that it allows you access to money you may not otherwise be able to obtain," says Arvin Sahakian, a co-founder of BeSmartee.com, a search engine for mortgages.

And it's a loan with a low interest rate.

"The best thing about doing this is the interest rate," says Jennifer Fredericks, a College Station, Texas-based real estate agent for Better Homes and Gardens Real Estate Preferred Living. "It's lower than it is for credit cards, and it's lower than it is for student loans."

"If you are using the money to improve your home or pay off higher interest rate loans, it makes perfect sense to choose this type of financing and improve your overall financial picture," Sahakian says.

There are other reasons homeowners commonly take out a second mortgage -- to pay off major medical bills that insurance wouldn't cover, to pay a kid's college tuition or to start a business. Whether a second mortgage is right for any of these purposes depends on the individual's views on debt and risk, especially when it comes to doing something like starting your own business, which, of course, could work out very well or go very badly.

The dangers. Not only can a business go bust, which is bad news if you're stuck paying off a second mortgage that funded a failed company, any number of things could go wrong that could mean you aren't only struggling to pay off your first mortgage and other bills -- you're now having trouble making payments on your second mortgage.

Even with a stable, reliable income, the danger of a second mortgage is that the interest rate on these loans is usually variable, McRae says.

"Currently, interest rates on these types of loans are alluring, but they will fluctuate with market conditions. Most second mortgage rates are tied to the prime interest rate," she says. "When you hear in the news that the Fed will meet to consider a rate increase, if and when that happens, the interest rate on the second mortgage will increase."

McRae adds that the Fed meets eight times a year to decide whether to change interest rates, "which means the rate on the line of credit could change eight out of 12 months of the year."

It might seem crazy to think about after all these years of low interest rates, but what goes down does sometimes go up, even way up, and you could easily wind up with a loan that has a high interest rate.

There's another potential problem, Fredericks says. "If the market were to change dramatically, and home values were to drop, you might be negative in your house as far as equity goes," she says.

If you're thinking about getting a second mortgage. Fredericks recommends talking to a reputable loan officer and getting his or her opinion. But whatever you do, don't borrow too much, she cautions.

"In California, a few years back, they were letting individuals borrow 125 percent of their loan, but when the market got bad, a lot of homes were foreclosed on," Fredericks says. "One of the reasons that Texas had less foreclosures during this period is because people were only allowed to borrow 80 percent of their equity. So, the moral of the story here is that, even if your state allows you to borrow more than 80 percent, you wouldn't want to go higher than that because you need to have a cushion in your value."

Second mortgages can be great if you use them properly, says Greg Cook, a mortgage originator based in Temecula, California, who runs a website for new homebuyers, FirstTimeHomeBuyersNetwork.com.

"A second mortgage is new debt that has to be repaid," Cook says. "Too often a consumer will use the proceeds to take on new additional debt. For example, a down payment on a car, toy hauler or to fund a dream vacation. Now it's debt upon debt."

So don't do that. Bottom line: You take out a second mortgage if you can solve a financial problem. You don't take one out to create a new one.

Geoff Williams is a regular contributor to U.S. News. He is also the author of several books, including "Washed Away," about the great flood of 1913, "C.C. Pyle's Amazing Foot Race," about the infamous Bunion Derby of 1928 and "Living Well with Bad Credit." You can follow him on Twitter@geoffw.

Originally published