When you hear the term “second mortgage,” a negative connotation may come to mind. You may be thinking, “Why would I need a second mortgage?” I’m not in financial distress! That’s the traditional view.
But times have changed, and gone are the days when homeowners put down large down payments and paid off their mortgages in a matter of years.
Nowadays, it’s quite common to hold two mortgages, typically in the form of a home equity line as part of a combo loan. The reason being is that home buyers are putting less and less down when they purchase properties.
However, because it can be difficult and/or more expensive to get a mortgage with little down, homeowners opt to get two loans instead of one. Let’s take a look at how that works.
Types of Second Mortgages
As mentioned, many homeowners carry both a first and second mortgage, often closed concurrently during a home purchase transaction. In these cases, the 2nd mortgage is referred to as a “piggyback loan” because it is taken out at the same time and sits behind the first mortgage.
Piggyback loans are used to extend financing terms, allowing borrowers to put down less on a home, or break up their loan into two separate amounts to produce a more favorable blended rate.
Two common formulas for a piggyback loan are an 80/10/10 loan or an 80/20 loan.
An 80/10/10 translates to 80% loan-to-value (LTV) on the first mortgage, 10% LTV on the second mortgage, and a 10% down payment. In essence, you’re putting down just 10%, but keeping your first mortgage at the important 80% LTV or less threshold to avoid mortgage insurance.
You may also get a more competitive interest rate if your first mortgage is at 80% LTV or lower.
For example, if the purchase price were $100,000, you’d get a first mortgage for $80,000, a second mortgage for $10,000, and bring $10,000 to the table in down payment money.
An 80/20 is an 80% 1st mortgage, a 20% 2nd mortgage, and zero down payment. Uh oh. These are less common today than they were in the early 2000s because lenders have become much more risk-averse.
Using the same example from above, you’d have an $80,000 first mortgage and a $20,000 second mortgage with no down payment whatsoever. This was a simple, yet risky way to get a mortgage with no skin in the game a decade or so ago.
Second mortgages can also be opened after a first mortgage transaction is closed, as a source for additional funds. These are known as “standalone second mortgages” because they are taken out separately, without disrupting the first mortgage.
Let’s say you bought that same $100,000 home, but came in with a 20% down payment. Over time, you would gain equity as the mortgage was paid down.
After say 10 years, you’d have quite the equity cushion, assuming home prices also appreciated. Let’s pretend the home is now worth $125,000, and your remaining loan balance is $75,000.
You’ve got $50,000 in equity to play with. You can either refinance your first mortgage to access that money, or alternatively open another standalone second mortgage to tap into it.
If it’s the latter option, homeowners can either elect to take a lump sum of cash in the form of a home equity loan, or opt for a home equity line of credit (HELOC), which allows them to draw specific amounts of money when needed using an associated credit card.
Keep in mind that you need equity in your home to execute this type of transaction.
Second Mortgage Rates
Monthly payments on second mortgages are typically pretty low relative to the first mortgage, but only because the loan amount is generally much lower. Interest rates on second mortgages can be quite steep, we’re talking 12% in some cases, so be sure to do the math to ensure it’s the right choice.
However, there are affordable options as well if you have good credit and a decent amount of equity in your property.
Second mortgages are offered in both adjustable and fixed-rate options, with home equity loans typically fixed and home equity lines of credit variable and tied to the prime rate.
If you go with a fixed option, expect the rate to be higher at the outset because you’re paying for the relative safety and stability of a rate that won’t adjust. I’ve seen second mortgage rates advertised in the high 4% range, which is pretty attractive, though the LTV is typically capped at 70% or nowhere close to 100%. Rates may range from 5-7% or higher for other, more typical scenarios.
If you go with a variable rate, such as a home equity line of credit, you might be able to get a rate below prime (currently 4.25%). I’ve seen rates advertised around 3-4%, which is generally a teaser rate for the first year. After that first year you might expect a rate of 4.25% or higher.
While the rates are similar to fixed seconds, they can come in handy if you just need temporary financing and want the lowest possible rate, or if you just want to borrow a small amount and pay it back fairly quickly. Also note that HELOCs come with an interest-only option during the initial draw period, as do some home equity loans early on.
In any case, just like first mortgages, you should have several options to choose from to find the right fit for your particular situation.
It might be in your best interest (the puns just won’t stop) to put more money down or explore other alternatives such as a larger first mortgage amount if the interest rate is sky-high on the second mortgage.
Advantages of Second Mortgages
Second mortgages that are closed concurrently with the first mortgage during a purchase transaction are also referred to as “purchase money second mortgages.” As mentioned earlier, these second mortgages allow homeowners to come in with a smaller down payment, or no down payment at all.
During a purchase transaction, the homeowner can break up the total loan amount into two separate loans called a combo loan. The risk is split between the two loans, allowing higher combined loan-to-values and lower blended interest rates.
Second mortgages in the form of piggyback loans also allow homeowners to avoid paying PMI, or private mortgage insurance. The savings can be quite substantial depending on how the loan breaks down, often saving the homeowner hundreds of dollars a month. If the first loan is kept at or below 80% loan-to-value, PMI needn’t be paid.
Additionally, breaking up your total loan amount between a first and second mortgage may allow you to keep your first mortgage under the conforming loan limit, which should help you obtain a lower interest rate if you’re in jumbo loan territory.
Second mortgages can also be opened after the purchase transaction is complete, as a home equity loan or home equity line of credit. This additional allowance of funds can provide a homeowner with much needed cash to improve the quality of their home or pay off high-interest loans, while avoiding a refinance of the existing first mortgage.
This can make sense if your first mortgage rate is fixed and super low, and you want to hang onto it. I expect this to be a common scenario thanks to those record low mortgage rates.
Disadvantages of Second Mortgages
Once you’ve got a second mortgage, it will be increasingly difficult to get any additional financing, such as a third mortgage. While it’s probably not common that a homeowner should require a third mortgage, emergencies do happen, and you may mind yourself trapped if you need more funds for any other reason.
Interest rates on second mortgages are typically quite high compared to first mortgages, and it’s quite common to receive an interest rate in the double-digits on a second mortgage. You could get a better deal with just one mortgage, or possibly even by paying mortgage insurance.
Many second mortgages are home equity lines of credit, which are tied to the prime rate. Whenever the prime rate is adjusted, the interest rate on your home equity line will change accordingly, effectively making it an adjustable-rate mortgage. When the Fed was raising the prime rate month after month in years past, many homeowners faced substantially higher monthly payments on their second mortgages.
Some home equity lines come with additional fees, such as an early closure fee, as well as minimum draw amounts that may exceed your personal needs. Make sure you read all the fine print to avoid any surprises.
Last but not least, second mortgages mean more debt, more interest due, and can potentially extend the amount of time it takes to pay off your first mortgage.
All that said, there are a number of pros and cons to opening a second mortgage, but they shouldn’t be looked upon as negative financing instruments, rather just another option to consider when seeking home loan financing.
One final note: Many mortgage lenders are reducing the availability of second mortgage programs as the secondary market continues to grapple with credit issues, so you may find it much more difficult to obtain one these days.
But second mortgages are still available, and can be found at a variety of banks and lenders and credit unions nationwide. The only difference now is that the LTV is often restricted to say 85-90%, versus 100% during the housing boom.
At the same time, there are still crazy loan programs like 125% second mortgages being offered by CashCall. So there’s plenty out there if you’re willing to pay a premium for it.