What is a Second Mortgage?

For some real estate investors, there’s an awkward stage in-between taking out their first mortgage and having it completely paid off where they may need access to money at affordable interest rates. All of the years that they have spent paying down their initial mortgage count for something. A real estate investor has a certain amount of equity in their property. A second mortgage will allow them to tap into that equity in exchange for cash.

How does a second mortgage work?

A second mortgage is a loan that you take out by using your property as collateral. You can’t take out a second mortgage for the entire value of your property because the amount that you still owe on your first mortgage will factor into the calculations.

The word “second” means that your second mortgage takes a backseat to your first mortgage. For this reason, a second mortgage is seen as a greater risk by lenders and carries a higher cost. If you default on your mortgage, then the holder of the first mortgage has to be compensated fully via the sale of the property before the second mortgage lender is paid.

A second mortgage will have a higher interest rate and you’ll need to pay additional fees like closing costs. You will need to pass a credit check, which will also have an influence on your interest rates. You’ll also need to prove that your income is sufficient to cover the costs associated with both mortgages.

Is a second mortgage a good idea?

If you’re here, you’re probably wondering if it’s a good idea to take out a second mortgage. The best answer to that question is that it depends. In some cases, it can be very financially prudent to unlock access to capital via property equity.

Using a second mortgage to access better interest rates to consolidate debts or to improve your property can be a diligent move, but using it to further fund a lavish lifestyle beyond your means will catch up to you quickly.

In the event of a financial emergency or an unexpected expense, this is an option to access a large sum of cash at a lower rate than credit cards or various other types of loans.

What are the different types of second mortgages?

The two primary types of second mortgages are lump-sum or line of credit.

  • Lump-sum: The real estate investor receives a single payment from the lender which is repaid to the mortgage lender in monthly payments. 
  • Line of credit: The real estate investor receives access to a predetermined sum and is able to borrow as needed rather than taking the entire amount at once.

Why would you get a second mortgage?

The main reasons that real estate investors cite for taking out second mortgages are for debt consolidation, to have access to cheaper capital than other sources, to improve their property, or to get around having to purchase expensive insurance.

A common scenario to consider a second mortgage is when you don’t have enough cash to meet the 20% down payment threshold on your first mortgage. There is a loophole of sorts where your second mortgage is considered by lenders as a down payment. 

If you aren’t able to meet the requirement of putting 20% down on your first mortgage, then you will often be required to purchase private mortgage insurance (PMI), which can get costly year after year. A second mortgage, in this case, allows you to avoid having this insurance, but you need to make absolutely sure you can afford it.

Think of it this way: Insurance companies have your back against the wall if you are required to buy PMI. If you want to purchase a property and don’t have a high enough down payment, then they know you will strongly consider buying this costly insurance. Having a way to get around this requirement can empower you to get the property you want without tying up as much cash.

Other uses for second mortgages are emergency medical expenses, to pay for a college education, or to purchase necessary equipment for a business if you don’t have access to other forms of capital.

How much can I borrow with a second mortgage?

In Canada, you can borrow 80% (or less, if you choose) of the appraised value of your property, minus the balance that you still owe on your first mortgage.

In America, some lenders will allow you to borrow up to 90% of the equity that you have accumulated in your property. Nonetheless, 80%-85% is more common.

What is a home equity line of credit?

A home equity line of credit (HELOC) is like the second type of a second mortgage that we referenced above. It’s the alternative to a lump sum payment. You can think of it as a credit card—except instead of having a staggeringly high interest rate, it is secured by your property. 

While it’s not a great idea to rely on credit cards and to carry a balance with them, if you already have credit card debt, then you could potentially wipe out most or all of that debt with a HELOC while still maintaining access to revolving credit as needed. The danger here is if you don’t decrease your spending nor increase your income, then you could fall back into the same credit card debt trap—except this time, you’ll also have second mortgage payments on top of it. 

What are some smart ways to take advantage of home equity loans?

Even if a second mortgage carries a higher price than your first mortgage, it can still be worthwhile to consider using this financial tool in a number of different cases.

To consolidate debt: If you have credit card debt or other debt that carries a higher interest rate than your home equity loan would cost, then it could be prudent to take out a second mortgage to pay off the higher-interest debts. 

To upgrade your property: If you’re thinking of selling your property, but it looks like it’s right out of a 1980’s Sears catalogue, then it can be a very worthwhile investment to take out a second mortgage in order to remodel your property. The same applies to landscaping, painting, a new roof, and other upgrades that will help curb appeal.

You can do this before you’re planning to sell your property, too. It can feel strange to put all of this money into remodeling when you’re about to move out. However, there’s nothing wrong with doing some work early so you can enjoy it for a few years. These upgrades will still increase the value of your property.

To generate income: If you could purchase a better widget for your business that would make you more productive or increase the rates that you’re able to charge, then this could be a very worthwhile investment.

What are some final thoughts about second mortgages?

A second mortgage is fairly straightforward. This secured loan gives real estate investors the ability to access cash at a lower rate than credit cards and other types of loans, so it’s useful to consolidate debt. However, it will increase your monthly payments in the process.