Home equity 101: how does a second mortgage work?

One of the most significant benefits of owning a home is the potential to build home equity, and, under certain circumstances, one might choose to tap into that equity to secure extra funds in the form of a second mortgage. This can either be accomplished via a one-time loan or a home equity line of credit (HELOC). Put simply, your equity is equal to the difference between the value of your home and your mortgage balance.

In a nutshell, when you take out a second mortgage, your home becomes collateral: although home equity loans offer very competitive interest rates, lenders place a second lien on your home, giving them rights to your property—along with the first mortgage lien—if you fail to keep up with payments. The more you borrow against your home, the greater the risk you’re taking.

How does a second mortgage work?

First things first: to calculate your home equity, subtract the amount you’ve paid off on your first mortgage (not counting interest) from the total amount you borrowed. If you’re working with a bank that offers a maximum CLTV ratio of 80%, your home is worth $300,000, and you still owe $150,000, you might be eligible to borrow another $90,000 when taking out that second mortgage. ($300,000 x 0.80 = $240,000 – $150,000 = $90,000). Naturally, the larger the balance of the loan, the higher the payments, but the interest rates on second mortgages tend to be lower than those on credit cards and unsecured debt. 

To qualify for a second mortgage, you’ll need a minimum credit score of 620, a maximum debt-to-income ratio (DTI) of 43%, and enough home equity to take actually take out a second loan, while also keeping about 20% of that equity in your first mortgage loan. Got all that?

Advantages and disadvantages

There are, of course, advantages and disadvantages to taking out a second mortgage, and it’s crucial you understand them well!

Second mortgages often come with low-interest rates, plus a tax benefit. Nonetheless, the risks are substantial. Let’s break it down, shall we?

Advantages of a second mortgage:

  • Allows you to access equity in your home for cash in hand
  • Can help make major expenses possible (i.e., like sending your child to college, or renovating your home)
  • Interest rates are lower than those associated with credit cards and other loans

Disadvantages of a second mortgage:

  • You risk losing your home if you can’t keep up with payments
  • Expenses include closing costs, appraisal fees, and credit checks
  • If you don’t have enough equity in your home or it doesn’t appraise high enough, you may not even be eligible for a second mortgage

Bottom line: for those who qualify, there’s no doubt that second mortgages can help cover huge and unexpected life expenses. They can also be a way of consolidating debt by using funds from your second mortgage to pay off other debts which carry even higher interest rates. Talk to a mortgage broker today to ensure you’re making a well-informed decision before you take that leap!

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