Second mortgages and mortgage refinances are other viable options for pulling equity from your home. A second mortgage adds another home loan to your plate, while a refinance replaces your current mortgage with a new one. This guide explores how each option works, their key benefits and drawbacks and what to consider when deciding if a second mortgage or refinance is best for you.
Understanding Basic Mortgage Terms
Before diving into the decision-making process, here’s what to know about second mortgages and mortgage refinances.
What Is a Second Mortgage?
As the name suggests, a second mortgage is an additional home loan that sits on top of your primary mortgage. This means you’ll have two separate mortgage payments monthly.
Second mortgages are secured by your home and allow you to borrow against your equity or portion of your home you own outright. If your home has significantly appreciated in value or you have paid down a good portion of your initial mortgage, a second mortgage can possibly grant you access to a considerable amount of funds.
What Does It Mean to Refinance Your Mortgage?
Refinancing refers to the process of replacing your current mortgage with a new one, which could come with better terms or a lower interest rate. Homeowners opt for refinancing to get a lower monthly mortgage payment or a better interest rate, extend or shorten the loan term, or remove a cosigner.
A cash-out refinance also allows you to withdraw a portion of your equity in cash. If you opt for this type of mortgage, you’ll get a larger loan, typically with different terms, that includes the funds you pull out.
Is a Second Mortgage and Refinancing the Same Thing?
Both options are often used to convert equity into cash, but they aren’t the same. As previously mentioned, a second mortgage is an added home loan with a separate monthly payment. But a mortgage refinance means you’ll get a new mortgage that replaces the existing one, giving you one monthly payment.
Second Mortgage vs. Refinance: Key Differences
Before applying for either of these options, it’s worth understanding the key differences between the two.
Pros and Cons of a Second Mortgage
Pros:
- Access to equity: You can tap into your home’s equity without altering the terms of your existing mortgage.
- Potential tax benefits: Interest paid on a second mortgage may be tax-deductible.
Cons:
- Additional payments: You’ll have an extra monthly payment on top of your primary mortgage.
- Interest rates: Typically, the rates for a second mortgage are higher compared to primary mortgages.
Pros and Cons of a Refinance
Pros:
- Lower interest rates: Refinancing can give you the opportunity to qualify for a lower interest rate, which can lead to significant savings over the life of your loan.
- Lower monthly payments: With a lower interest rate, you may be able to lower your monthly mortgage payments, freeing up funds for savings or other expenses.
- Change loan term: Refinancing can allow you to choose a shorter or longer loan term, depending on your financial goals and situation. Additionally, if you currently have an adjustable-rate mortgage, refinancing can allow you to convert to a fixed-rate mortgage or vice versa.
Cons:
- Closing costs: Refinancing comes with closing costs, which can add up to thousands of dollars. Make sure to factor in these costs when deciding whether to refinance.
- Qualification requirements: Refinancing requires you to meet certain qualification requirements, such as having good credit and a low debt-to-income ratio.
- Risk of losing equity: If you’re refinancing to take out cash, you may be risking your equity and potentially accumulating more debt.
When It’s Best to Choose a Second Mortgage
A second mortgage is ideal if your current mortgage has a low interest rate and you want to avoid a full refinance. It’s also best if you need a smaller amount of cash or if you’re considering a home equity line of credit (HELOC) to access on an as-needed basis.
When It’s Best to Choose a Mortgage Refinance
A mortgage refinance may be a wiser choice if current market rates are lower than your existing rate and you’re looking to reduce your monthly payments over a new term. You can also choose a cash-out refinance to get a lump sum of cash for larger expenses. However, a term refinance could adjust the length of your mortgage, potentially saving you money over time.
Choosing Between Second Mortgage vs. Refinancing
Still torn between a second mortgage and mortgage refinance? Evaluate these factors to make an informed decision.
Assessing Your Financial Situation
Begin by evaluating your current financial situation. Do you require a lump sum of cash, or are you looking for a way to lower your overall mortgage payments?
A second mortgage might be suitable if you need cash for a specific purpose, like home improvements or consolidating high-interest debts. On the other hand, if your goal is to reduce your monthly payment or the overall cost of your loan, considering a refinance deal might be the better approach, especially if current market rates are lower than the rate you’re currently paying on your mortgage.
Evaluating Your Credit Score
Your credit score plays a pivotal role in determining your eligibility for home financing options. A higher credit score can unlock lower interest rates and better terms, whether you are applying for a second mortgage or looking to refinance.
Be sure to check your credit score before applying and improve it if necessary. Also, dispute any errors in your credit report that could be lowering your score.
Understanding the Market Conditions
Keep an eye on the current mortgage rates and how they compare to the rate you’re currently paying.
If market rates are attractive, refinancing could lower your interest rate and monthly payments. However, if rates are higher than your existing mortgage or only slightly lower, then taking out a second mortgage could be more cost-effective, especially if you have substantial home equity and need the extra funds.
Keep in mind that a cash-out refinance could also allow you to access your home equity while potentially improving your loan terms.
Crucial Factors to Consider Before Making a Decision
Here are a few more factors to consider before making a decision and formally applying with a lender.
Interest Rates
With a second mortgage, you usually receive a fixed rate that remains constant over the life of the loan. A refinance could either lower your current interest rate if you opt for a traditional refinance or change based on whether you choose a fixed-rate or an adjustable-rate mortgage.
Loan Terms
The loan terms can differ significantly between a second mortgage and a refinance. A second mortgage is an additional loan with its own term, often 15 to 20 years.
When you refinance, you can potentially extend or shorten the term of your existing mortgage, impacting the total interest you’ll pay and your monthly cash flow.
Fixed-rate loans provide stable payments, while adjustable rates may offer lower initial payments but carry the risk of rate increases. It’s essential to evaluate how these terms align with your long-term financial plans.
Fees and Other Costs
Both options come with various costs and fees.
Refinancing can include closing costs ranging from 2 percent to 6 percent of your loan amount, affecting the immediate money you’ll need to pay upfront or roll into your loan.
It’s important to keep in mind that while a second mortgage may have lower upfront costs, it could result in higher borrowing costs over time.
Requirements for Qualification
Finally, assess the eligibility guidelines to determine if you’re a good fit for either option.
Lenders might require a higher credit score for a second mortgage as it represents an increased risk. For refinancing, especially a cash-out refinance, you may need more equity in your home and a stable income to secure favorable terms.
Second Mortgage vs. Refinancing: Which One Is Right for You?
When deciding between taking out a second mortgage and refinancing your current loan, it is important to consider your financial goals and the equity in your home.
To recap, a second mortgage, or a home equity loan, allows you to borrow against the equity in your property. You receive this as a lump sum and typically at a fixed interest rate. Refinancing, on the other hand, involves replacing your existing mortgage with a new one. It can adjust your interest rate and loan terms and potentially reduce your monthly payments. If you’re considering a cash-out refinance, this even lets you tap into your home’s equity and receive extra funds.
When choosing a second mortgage, you’ll still be responsible for your original mortgage’s monthly payment plus an additional payment for the new loan. This is ideal if you want to retain your original mortgage’s interest rate, perhaps because it’s lower than current market rates.
But if current interest rates are lower than your existing mortgage or you want to change the loan term, refinancing might be your best choice. This can lead to potentially lower monthly payments across the board and streamline your debt into one payment.
Before making a decision, consider your financial situation. Do you need a specific lump sum of money now? Are you looking to lower your overall monthly costs? Each option carries its own set of risks and benefits—assess these carefully and how they relate to your financial goals to make the best choice for you.
FAQs About Second Mortgage vs. Refinancing
Below are some commonly asked questions that will clarify the differences between taking out a second mortgage and refinancing your home.
Yes, you can pull equity out of your house with a second mortgage, a separate loan in addition to your primary mortgage. This allows for access to funds without altering the terms of your first mortgage.
Second mortgages come in two forms: a home equity loan, where you receive the money as a lump sum, or a home equity line of credit (HELOC), which works like a credit card with a percentage of your home equity the limit. And for the latter, you’ll only pay interest on the amount you withdraw.
The cost of a second mortgage depends on multiple factors, such as the loan amount, your credit score, and the lender’s fees.
Generally, you can expect to pay for an appraisal, an origination fee and other closing costs, which typically range from 2 percent to 6 percent of the loan amount.
To illustrate, taking out a $100,000 second mortgage of $100,000 will typically cost you between $2,000 and $6,000. Furthermore, the interest rates on second mortgages tend to be higher than those on primary mortgages because the lender assumes more risk.
