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Updated on Monday, February 4, 2019
One of the best feelings associated with homeownership comes from seeing the amount of equity in your house increase. Equity is the portion of your house that you own outright. It’s calculated by subtracting what you owe on your house from the amount your property is worth. As you pay down the mortgage or your house increases in value, you’ll own more of the house in the form of equity, and that can become one of your greatest assets. When you have a lot of equity, you can borrow against it to use the money for financial goals. A second mortgage allows you to do that.
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There are a number of reasons a borrower might take out a second mortgage, in addition to their primary one.
- They may want to use the money to make major home improvements that they couldn’t otherwise afford.
- They may decide to borrow against their equity to pay off other high-interest debt.
- They may choose to use the money to fund a small business or pay for a child’s college education.
In other words, if a homeowner is in need of a significant amount of money for any reason, a second mortgage could provide the capital he or she needs.
However, like all debts, second mortgages come with a cost. You must pay interest on the money that you borrow. Sometimes homeowners may find that refinancing a second mortgage can save them money in the long run.
Types of second mortgages
Second mortgages come in a variety of different stripes:
A HELOC, or home equity line of credit, is just what it sounds like — a line of credit borrowed against your equity. Just as a credit card allows you to borrow money when you need it, a HELOC is an account from which you can borrow at will. You’ll be charged interest only on what you borrow, and you’ll be expected to make at least minimum payments on the debt. HELOCs typically have adjustable interest rates, meaning the amount of interest you pay can fluctuate over time. After what’s known as a “draw period,” you can no longer make withdrawals from the HELOC, and in some cases, the remaining balance may be due immediately.
A home equity loan (HEL) is another type of second mortgage. In this case, you take out a lump sum and pay the loan back in installments. Home equity loans typically have fixed interest rates, so your payments will likely remain the same throughout the life of the loan.
Another type of second mortgage is a piggyback mortgage loan. A piggyback mortgage is one that’s taken out at the same time that you take out a first mortgage. Its purpose is to help borrowers buy a home when they don’t have a lot of money for a down payment. Piggyback mortgage loans can also help you to avoid paying private mortgage insurance (PMI).
For conventional loans, you typically must put down at least 20% and finance no more than 80% of the loan in order to avoid paying PMI. With an 80/10/10 piggyback loan, you still only finance 80% of the loan with the first mortgage. However, you take out a second piggyback loan to pay 10% and you only put down 10% on the house. Two things you should know about piggyback loans: The second, smaller loan typically has a higher interest rate than the first mortgage loan, and it often has an adjustable rate, meaning the interest rate can fluctuate after an introductory period.
Reasons to refinance a second mortgage
Just as you can refinance a first mortgage, you can refinance a second mortgage. There are a number of reasons why a homeowner may choose to do so.
Interest rates have gone down. If interest rates have gone down since you initially took out the second mortgage, it may make sense to refinance to a lower rate. By refinancing to get a lower interest rate, you would save money on interest and you may end up with a lower monthly payment.
Your credit outlook has changed. You may have paid down debt or bounced back from a financial challenge and in the process, your credit score may have improved. With a higher credit score, you may now qualify for a lower rate if you refinance.
You want to lock in a fixed rate. If your second mortgage has an adjustable rate, you may want to refinance to get a fixed rate, particularly in a rising-interest-rate environment. That would give you the peace of mind in knowing that your interest rate won’t rise and your payments will stay the same for the life of the loan.
You want to change the terms of the loan. You might be able to get more favorable terms on the loan by refinancing. For example, you might change the length of the loan from 30 years to 15. A shorter-term mortgage is likely to come with a lower interest rate, although your monthly payments will be higher.
You want to borrow more money against your equity. Perhaps your equity has increased and you want to take out a larger second mortgage. Refinancing the initial loan could allow you to do that.
Steps to refinancing a second mortgage
If you think it makes sense to refinance a second mortgage, consider the following steps:
Determine how much it will cost you. Refinancing is not free. In fact, refinancing fees can easily equal as much as 3% to 6% of the loan. Make sure the benefits are worth it.
See if you’re eligible for a new loan. Lenders look at a number of factors such as your credit score, your income and the amount of debt you have. Lenders also use loan-to-value (LTV) ratios to guide their lending decisions. For example, a lender with an LTV ratio standard of 90% will only lend up to 90% of the house’s value. If the amount of the loan doesn’t fall within that lender’s LTV ratio guidelines, you may not be able to refinance.
Shop around and compare lenders. While you may decide to stick with the same lender, you might be able to get better terms from someone else. Don’t just look at the interest rate offered; calculate and compare the amount you would spend in closing fees, too.
Gather your paperwork. There are certain documents that lenders are likely to require. Among them are W-2s and other proof of income, tax documents, bank statements, investment account statements and current debt statements. If you have everything together, the application process will be easier.
Apply for the loan. While you go through the application process and wait for the deal to close, continue to make payments on your current second mortgage so you stay current on your account.
A note on taxes
One longtime benefit of home equity loans and HELOCs was that homeowners could deduct the interest on their tax returns. However, that changed when the Tax Cuts and Jobs Act of 2017 went into effect. As a result of that tax law, you can now only deduct interest from home equity loans and HELOCs if the loans are used for home improvements, according to the Internal Revenue Service (IRS). If you’ve been thinking about taking out a second mortgage to do some renovating, you can take advantage of the tax deduction. If not, make sure there are enough other benefits to justify the costs.
When it comes to your finances, you should always be looking for ways to get the most for your money. Sometimes refinancing can help you to do that. But the decision to refinance any mortgage should never be taken lightly. If you’re thinking about refinancing a second mortgage, make sure you weigh all the costs and benefits to make sure it’s the right decision for you.