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Chapter 2: Second Mortgages
If you already have a first (primary) mortgage, another loan taken out against your home is called a second mortgage. Second mortgages come in two basic forms: home equity loans and home equity lines of credit. Both types typically offer higher interest rates than primary mortgages because the lender assumes greater risk – in the event of foreclosure, the first loan will be repaid before any seconds. However, because the loan is still secured by the property, interest rates for second mortgages tend to be lower than for unsecured debt, such as credit cards.

Home equity loans
With a home equity loan, you receive cash in one lump sum at closing. Once you get the money, you cannot borrow further from the loan. The repayment period is often fifteen years, although it can be as little as five or as great as thirty years. Both the interest rate and the monthly payments for a home equity loan are usually fixed, meaning they do not change over time.

Home equity lines of credit (HELOCs)
A HELOC is a type of revolving credit. It operates similarly to a credit card. You can withdraw money, up to your credit limit, at any time during the draw period. Some lenders set a minimum required withdrawal amount or charge transaction fees every time you draw on the line. During the draw period, you typically are only required to pay the interest, although you can choose to pay principal as well. Once the draw period is over, you may have to repay the principal in full, be allowed to repay the principal over a fixed period of time, or have the option of renewing your draw period, depending on how the HELOC is set up.

The interest rate for HELOCs is usually variable, meaning it can change over time. It is usually calculated as a base index, such as the prime rate – the rate financial institutions give their most creditworthy members – plus a margin. Because the interest rate determines your monthly payments and how much borrowing will cost you, it is a good idea to find out how much the rate can change and if there is a cap that will prevent it from exceeding a certain amount.

How much can you borrow?
How much you get from a second mortgage is based on your home equity, since it is your equity that is serving as collateral for the loan. (The lender will likely also consider your credit score, income, and other factors.) Every lender sets a different limit, although it is commonly less than the full amount of equity. For example, a lender may let you borrow up to 80% of your home’s appraised value minus the amount left on the first mortgage. Still, there are some lenders that may let you borrow up to the amount of equity you have or even more. It is never recommended that you borrow more than your equity. This puts you “upside-down”, meaning you owe more on your mortgages than what you can sell your property for. It can be difficult, if not impossible, to sell your home while you are upside down.

What a lender is willing to give you is not the only factor to consider. You should also consider what you can afford to repay. The more you borrow, the higher your monthly payments are. You can use the calculator below to estimate what your payments could be for a home equity loan or home equity line of credit during the repayment period. (To calculate a payment for a HELOC during an interest-only draw period, simply multiply the expected balance by the interest rate and divide by twelve.) Remember, home equity loans and lines of credit are secured loans. If you do not make the payments, the lender can foreclose on your house, just like if you do not pay your primary mortgage.



What to look for
Looking for a loan with the lowest annual percentage rate (APR – the cost of borrowing expressed as a yearly rate), is a good idea, since the lower your interest rate, the less borrowing will cost you. However, you don’t want to stop there. Do you remember all of the closing costs that had to be paid when you took out a mortgage to purchase your home? You have these costs when you take out a home equity loan or line of credit too. Consider what fees each lender charges. For example, you may have to pay an application fee, an appraisal fee, and points. Be cautious of loans that come with potentially detrimental features, such as a large balloon payment at the end of the loan or a prepayment penalty.

Should you go with a home equity loan or a line of credit? Because the APR for home equity loans and HELOCs are calculated differently, comparing the two isn’t easy. The APR for home equity loans may include points and other finance charges, while the APR for a home equity line is only based on the periodic interest rate. Comparing APRs may not be helpful, but you can consider what you will use the funds for. People generally take out home equity loans to pay for a specific, one-time cost, such as credit card debt or an addition. Conversely, when people expect to use the funds over a period of time, a HELOC is often used.

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