How Does a Second Mortgage Work

"How does a second mortgage work?" is a common question that arises when discussing real estate. A second mortgage is similar to a first mortgage because your home secures the debt. If you default, or fail to pay, your second mortgage loan, the bank can seize the home and sell it at auction to collect on the debt. In order to qualify for a second mortgage, your home must be worth more then you owe on the first mortgage. In other words, you must have equity in your home.

Types of Home Loans

You need to understand when to apply for a second mortgage in order to understand how second mortgages work. There are a number of different reasons to apply for a second mortgage. Some people apply for a second mortgage when they initially purchase their home. Instead of making the down payment on the home with their own money, in selected situations banks will allow you to borrow the full value. Because you are usually required to have some type of down payment to qualify for a first mortgage, you are generally unable to get one single mortgage for the full value and instead may use two mortgages.

In fact, if you put less than a 20 percent down payment on your first mortgage, you are required to pay an additional fee each month called "Private Mortgage Insurance" or PMI. Instead of putting less then 20 percent down on the home and paying for private mortgage insurance, many people borrow 80 percent of the value of their home in their "first" mortgage, and borrow the 20 percent down payment required in a second mortgage. This is called an 80-20 mortgage, and it allows people to buy a home they might otherwise be unable to afford at the time. It can be risky, however, because you have no "equity" in your home: the bank(s) that hold your first and second mortgage notes own it entirely.

Some people also apply for a second mortgage in order to "tap into" their home's equity to raise cash. If you put money down when you a buy a home or the value of your home goes up, then you have "equity" in your home, or a financial interest in the house. You can get that money out of the home and turn it into cash by taking a second mortgage. People do this for a number of reasons: to raise money for home improvements, to use the cash to pay down high interest debt or medical bills, or simply to get a hold of a lump sum of cash for any reason. You can also create a home equity line of credit which essentially gives you a large sum of money that you can use like a credit card to buy anything you want; except, unlike a credit card, your home secures this line of credit.

Whether you are buying a home for the first time using an 80-20 mortgage, or tapping into the equity on a home you already own, the house must be worth enough after the first mortgage is paid to guarantee the debt. In other words, if you owe $100,000 on a home valued at $120,000, you are eligible for a $20,000 second mortgage. If you want to buy a $120,000 house, the maximum amount of money you can borrow on your first and second mortgages combined is $120,000.

Typically, the second mortgage process begins when you apply for a second mortgage at a bank or other lending institution, such as a credit union. Often, people apply for a second mortgage with the same bank that holds the note on the first mortgage, i.e. the bank they already owe money to on the house.

The bank may send someone to appraise your home to determine the value. The perspective borrower often pays this cost, either directly or in the form of mortgage fees. You will also need to provide important financial information, such as your credit score and income. These three factors combined will determine whether you are eligible for a second mortgage, and how much money you can borrow.

If you are approved for a second mortgage, then the formal loan process begins. You will need to fill out documents and paperwork, and pay closing costs. Typically, no title search is required because a title search was already completed on the first mortgage. In some cases, especially if you work with a new lender, a title search may be performed to ensure that there are no creditors who have a lien on your home.

After approval, the money from the second mortgage is available to you. The bank may give you a check for the loan amount, or establish your home equity line of credit that you can use as needed. Many home equity lines of credit actually give you a card very similar to a credit card that you can use to charge purchases and withdraw money from an ATM.

The interest rate on most second mortgages is higher then the interest rate on first mortgages, since they are a higher risk loan. The risk is higher because the holder of the first mortgage has first claim on the home, or proceeds from the sale of a home in the event of foreclosure.

Monthly payments are usually required on second mortgages, just as they are on first mortgages. The interest may or may not be tax deductible, depending on the circumstances of the loan, your income, and other relevant factors under state law.

Armed with this knowledge of when and why to apply for a second mortgage, your question of how does a second mortgage work should now be answered. If you still have more thoughts, please use the comment box below!

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