Should I Get a 2nd Mortgage or Home Equity Loan? Everything You Need to Know

If you’re a homeowner, you may have heard about tapping into your home’s equity through a 2nd mortgage or home equity loan. But what’s the difference between these two options? And how do you know which one is right for your situation?

In this comprehensive guide, we’ll explain what 2nd mortgages and home equity loans are how they work and when it makes sense to use each type of loan.

Whether you need cash for home renovations debt consolidation or a major purchase, understanding these home equity financing options can help you make the smartest choice. Let’s dive in!

What is a 2nd Mortgage?

A 2nd mortgage is exactly what it sounds like – a second loan that you take out on a property you already have a mortgage on. The first mortgage is generally the one you used to purchase your home originally.

With a 2nd mortgage, you are borrowing against the equity that you’ve built up in your home. Equity is defined as the portion of your home’s value that you actually own, rather than the bank.

For example, if your home is worth $500,000 and you owe $300,000 on your existing mortgage, you have $200,000 in equity. A 2nd mortgage allows you to leverage that equity to get cash now.

Some common types of 2nd mortgages include:

• Home Equity Loan – A lump sum loan with fixed payments and interest rate
• Home Equity Line of Credit (HELOC) – A revolving line of credit with variable rates
• Cash-Out Refinance – Refinancing your current mortgage for a higher balance

No matter what type it is, a 2nd mortgage uses your home as collateral. This means if you default, the lender can foreclose and take possession of your house.

How Does a 2nd Mortgage Work?

When you take out a 2nd mortgage, the new loan is subordinate to your existing first mortgage. This means your first mortgage lender gets paid before the 2nd if you were to default or go into foreclosure.

For this reason, 2nd mortgages typically have higher interest rates and stricter eligibility requirements than first mortgages. The lender views you as a higher credit risk since you already have a mortgage payment.

The amount you can borrow with a 2nd mortgage depends on how much equity you have, as well as the lender’s specific underwriting policies. Many lenders will let you borrow up to 80-90% of your equity.

You’ll make monthly payments on your 2nd mortgage, in addition to your existing mortgage payment. The loan term is usually shorter than a first mortgage, often 5-20 years. With proper planning, a 2nd mortgage can be an affordable way to access your equity. But taking on another monthly payment does require budgeting carefully.

What is a Home Equity Loan?

A home equity loan is a type of 2nd mortgage that gives you a lump sum of cash upfront. You’ll pay this loan back over a fixed term with the same principal and interest payment each month.

Home equity loans have set interest rates, loan terms, and monthly payments. This helps make your repayment predictable. Loan terms are often 10-20 years, but can range from 5-30 years.

When you take out a home equity loan, the funds are dispersed to you at closing. You can use this cash any way you want – home improvements, debt consolidation, college tuition, or any other major expense.

With a home equity loan, your home serves as collateral. So defaulting can put your home at risk. Make sure to only borrow what you can comfortably afford to repay.

Home Equity Loan vs. HELOC

A home equity line of credit (HELOC) is another popular type of 2nd mortgage product. Like a home equity loan, it uses your home as collateral to give you access to cash.

But unlike a fixed loan, a HELOC works more like a credit card. Your lender approves you for a set borrowing limit and you can draw against that credit line as needed.

HELOCs have variable interest rates, meaning your payment can go up or down over time. They also have an initial draw period (usually 10 years) and later repayment period. This flexibility allows you to access funds on an ongoing basis.

A HELOC tends to make more sense if you have fluctuating borrowing needs. But a home equity loan offers more predictable payments. Evaluate both options to see which fits your situation best.

Should I Get a 2nd Mortgage? Pros and Cons

Second mortgages can be a smart way to tap home equity. But there are some key pros and cons to consider first:

Pros

• Access equity without selling your home or refinancing
• Typically lower rates than other loan types
• Interest may be tax deductible (consult a tax pro)
• Versatile – can be used for anything
• Quicker to close than refinancing

Cons

• Closing costs and fees
• Higher rates than 1st mortgages
• Your home is collateral – risk of foreclosure
• Another monthly payment to budget
• Shorter loan terms mean higher payments

As you can see, there are valid reasons both for and against getting a 2nd mortgage. Make sure to think through how taking on another payment could impact your monthly budget and financial plans.

When Does a 2nd Mortgage Make Sense?

While they aren’t right for everyone, here are a few instances where a 2nd mortgage can be a smart move:

• Home improvements – Renovations and upgrades that increase your property value
• Debt consolidation – Pay off higher interest debts with a lower rate
• Major purchase – Financing a high-cost purchase like a car, boat, or RV
• College tuition – Paying for a child’s education at lower rates
• Medical expenses – Covering uninsured costs of a major procedure
• Starting a business – Funding startup costs for a new venture

The key is using 2nd mortgage funds for purchases that will benefit you over the long run. Taking on another payment just to finance a vacation or splurge may not be financially wise.

Tips for Getting the Best 2nd Mortgage

If you’ve decided a 2nd mortgage makes sense for you, here are some tips to make sure you get the best loan:

• Shop around – Compare offers from multiple lenders to find the lowest rates and fees. Online lenders often offer competitive pricing.

• Check your credit – Good credit scores of 700+ qualify you for the lowest rates. Review your credit reports first and dispute any errors.

• Ask about closing costs – Closing costs range from 2-5% typically. Ask what fees apply and if any can be waived or lowered.

• Choose shorter terms – Opt for the shortest term you can afford to pay the loan off faster and save on interest.

• Make extra payments – Making even occasional extra payments helps you pay off the balance faster and saves money.

• Consider fixed rates – While variable rates start lower, fixed rate loans offer predictable payments that protect you when rates rise.

Doing your homework upfront can help ensure you get the best possible deal on your 2nd mortgage.

Alternatives to Consider

While they can be useful tools, 2nd mortgages aren’t your only option for accessing home equity. Here are a few other possibilities to consider:

• Cash-out refinance – Refinance your current mortgage for a higher balance
• Home equity line of credit – A revolving credit line with variable rates
• Personal loan – An unsecured loan for debt consolidation or other uses
• 401k loan – Borrow from your own retirement savings (with risks)
• Family loan – Borrow from relatives; formalize terms for repayment

Each alternative has its own pros, cons, rates, and qualifications. Be sure to explore all your options before deciding the best route.

The Bottom Line

As you can see, 2nd mortgages and home equity loans allow homeowners to leverage equity for cash. While they work similarly, there are some key differences:

• Home equity loans offer fixed rates and payments, while HELOCs have variable rates and flexible limits.
• Interest rates and terms vary, so shop around for the best offers.
• Closing costs, tighter eligibility standards, and monthly payments are downsides to consider.

Tap into your home equity strategically and you can put your equity to work. But make sure you evaluate both risks and benefits first. With proper planning, a 2nd mortgage can help you achieve your financial goals without putting your home at risk.