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When it comes to using the value of your home to free up funds, there are a couple of ways you can do so by using your home as collateral. Two common ways are to refinance your primary mortgage or take out a second one. Potentially high interest rates, financing fees, and other closing and credit costs can add up when you try to borrow. However, with that said, if used correctly, borrowing can be a beneficial tool to add value to your home, help with large expenses, and consolidate high-interest debt.
What is a Second Mortgage? What is a Home Equity Loan? What is a Home Equity Line of Credit (HELOC)?
Mortgages occur when you establish a lien on your property by pledging it as collateral in order to receive financing from the bank. A lien is the claim or legal right of a lender to possess and seize your property if you fail to repay the loan on time. It serves to guarantee an underlying obligation – in this case, your mortgage repayment. A second mortgage involves taking out a second lien on a property that already has a primary mortgage attached to it. In other words, with a second mortgage, you pledge your property as collateral for a second time to secure financing.
This can benefit individuals with home equity and limited cash reserves that have expenses they need or want to meet. Unlike certain types of loans, you can use the money you receive from your second mortgage for practically anything. Also, interest rates on second mortgages are usually lower than ones on credit cards, making them particularly useful for significant expenses.
Second mortgages come in two varieties: a home equity loan and a home equity line of credit (HELOC).
Home Equity Loan
A home equity loan allows you to utilize a portion of the equity you have built up in your home to receive a lump sum of cash from the lender. These loans are issued with a fixed interest rate for a set time (usually between 5 and 30 years). Therefore, these loans are easier to budget for – by knowing the fixed rate, you will know exactly what your monthly payment will be and what paying it off will look like over time.
These are great if you need the money for a large one-time expense for which you know the cost. However, these are usually not the best option if you only need a relatively small amount of cash, as lenders typically have a minimum amount they will let you borrow. Additionally, similar to your first mortgage, you will have to pay closing costs.
In addition, your loan's interest rate depends on the points (prepaid interest) you pay in advance to receive the loan. Each point equals one percent of the loan amount. Therefore, the tradeoff is that this upfront interest payment lowers the interest rate of your loan overall, which may help you pay less over time. However, it also means that you will have to pay more at the start of the loan. Conversely, if you do not pay points, your interest rate will be higher, and you may pay more over the loan's lifetime. Lenders often give you options between the points you pay and the corresponding interest rate.
Home Equity Line of Credit (HELOC)
Rather than receiving money in a lump sum like with home equity loans, home equity lines of credit (HELOCs) are a revolving source of funds. Like credit cards, HELOCs have a limit, and you can access funds as you need them for a set period. Therefore, HELOCs are great if you need extra money intermittently rather than for one large purchase where you know the total amount. Most lenders offer different options for accessing those funds, whether through an online transfer, check, visit a branch ATM, or a bank card connected to the account. HELOCs also have closing costs; the types of fees and the amount charged vary by lender.
Another significant difference between HELOCs and home equity loans is that HELOCs are usually issued with variable interest rates, meaning your interest payment will change based on current interest rate levels. Some lenders are starting to offer fixed-rate HELOCs or hybrid HELOCs, which allow you to repay a portion of your debt at a fixed interest rate and the rest at an adjustable rate. However, these HELOCs also tend to have restrictions on withdrawal terms.
A HELOC operates in two phases that separate when you can borrow from the revolving line of credit and when you can no longer withdraw funds and must make repayments. These two phases are called the draw and repayment periods.
The draw period is when the funds are open and available for use. You can borrow as needed up to your credit limit and make minimum (interest-only) monthly payments on the amount you have taken out. You can also make additional principal payments during the draw period, and this can help save you in interest in the long run. If you reach the limit, you will have to pay off a portion of the amount before you can borrow more.
The repayment period occurs after you have reached the end of the draw period and is when you no longer have access to the line of credit. If you have yet to start making payments that cover the loan's principal and interest, you will have to start making full monthly payments. This means that if you have been making interest-only payments up to this point, your monthly minimum payment could increase substantially.
The length of each of these phases depends on your loan; however, HELOCs are usually issued with 30-year time frames – 10 years for the draw period and 20 years for the repayment period.
Overall Differences Between Home Equity Loans and HELOCs
| Home Equity Loan | HELOC |
|---|---|---|
Best Use of the Funds | One-time, large lump sum purchases. | If you require access to funds on an as-needed basis over a period of time. |
Disbursement | One lump sum. | As-needed, revolving line of credit. |
Repayment | Begins when the funds are disbursed. | Usually interest-only payments during the draw period, and then full principal and interest payments during the repayment period. |
Monthly Payment | Fixed | Typically variable, though the lender may cap your rates or offer a fixed-rate or hybrid HELOC. |
Interest Rates | Fixed | Again, typically variable, though there are fixed-rate or hybrid HELOCs available. |
Points | May be points you need to pay, but can be negotiated. | No points. |
Closing Costs | 2-6% of the loan amount, depending on the points you pay. | Vary, but can be lower than a home equity loan. |
Qualifying for a Home Equity Loan/HELOC
While the exact requirements for receiving a second mortgage depend on the lender, there is a baseline level you must meet before receiving funds.
Reliable income. Lenders will ask for some form of proof of income.
Good Credit. Having quality credit demonstrates to lenders that you pose a lower risk of defaulting on your loan. Typically, you want your credit to be at least in the mid-600s before you apply, but a score above 700 is ideal.
Qualifying Equity Amount in Your Home. Lenders usually ask that you have at least 15-20% home equity. We discuss how to calculate the equity you have in your home in the "How Much Can I Borrow With a Home Equity Loan or HELOC?" section below.
Low Debt-to-Income (DTI) Ratio. Some lenders may require a DTI below a certain threshold – the lower your DTI, the better.
Disadvantages & Advantages of Second Mortgages
Advantages
Flexibility for how you can use the funds. Both home equity loans and HELOCs have a ton of flexibility in how you can use the funds. While certain loans (i.e., student or car loans) have specific purposes, home equity loans and HELOCs can be used for virtually anything. Plus, HELOCs have the bonus of being able to borrow against your credit line at any time, and your untapped funds will not be charged interest. For this reason, if used correctly, HELOCs can be an additional source of emergency funds so long as the lender does not require a minimum withdrawal.
For home equity loans, there are predictable repayment costs. Due to the fixed-rate feature of home equity loans, you can plan exactly what your repayment schedule will look like over time.
You can draw on your credit line as needed for HELOCs. Unlike home equity loans which are a one-time lump sum receiving of funds, you can withdraw money from your home equity line of credit as needed. Plus, you will not need to make interest payments on the amount in your credit line you do not borrow.
You may be able to deduct some or all of the interest you pay on a home equity loan or HELOC. Interest on home equity loans and lines of credit may be tax deductible only if the money you borrow is used to "buy, build, or substantially improve the taxpayer's home that secures the loan" (per the IRS). This has nuances, so you should consult a financial advisor or tax professional to determine if the interest on your use of the funds is tax deductible.
Disadvantages
Collateralizing your home and reducing the equity in your home. The most significant risk with a second mortgage is putting a second lien on your home. If you cannot make payments on your home equity loan or HELOC, you risk losing your home to foreclosure.
Upfront closing costs. Like first mortgages, second mortgages have their own fees to close on the loan. The amount might interfere with your savings or overall financial plan if you are unprepared.
For HELOCs, making interest-only payments during the draw period could mean significant payments during repayment. During the draw period, you can make small, interest-only payments. However, if you continue to spend your HELOC during the draw period and make interest-only payments, it could mean a sharp spike during the repayment period, resulting in a financial shock.
Some borrowers may be tempted to use funds for nonessentials. A second mortgage can be a great use of your home's equity to continue building wealth. However, if the funds are allocated to nonessential purchases, it could cause financial hardship.
How Much Can I Borrow With a Home Equity Loan or HELOC?
To protect the lender and reduce the possibility that you will default on your loan, lenders usually will not let you borrow against all of your home equity. This is done to keep your loan-to-value (LTV) ratio below a certain percentage – typically the maximum being 80 to 85%.
As discussed previously, most lenders will require that you have at least 15-20% equity in your home. To calculate this, take the current value of your home and subtract your outstanding mortgage amount. This will give the dollar amount of equity you have in your home. Then, divide that number by the value of your home and multiply it by 100. This is the percent equity you have in your home.
For example, let's say you own a home worth $500,000 and have $200,000 left on the mortgage. That means the percent equity you have in your home is 60% ($500,000 - $200,000 = $300,000 / $500,000 = 0.6 x 100 = 60%).
Calculating your maximum home equity loan from there is relatively straightforward – you take the equity in your home as a dollar amount and multiply it by the lender's allowable loan-to-value ratio.
Using the example above, let's say the bank will write you a loan with an LTV ratio of 85%. That means the maximum amount you can borrow is $255,000 ($500,000 - $200,000 = $300,000 x 85% = $255,000).
To determine your maximum credit amount for a HELOC, multiply your home's value by the lender's LTV percentage. This will give you the maximum amount of borrowable equity. Take that value and subtract what you currently owe on your mortgage. This gives you the HELOC credit limit.
Continuing to use the example above, your HELOC credit limit would be $225,000 ($500,000 x 85% = $425,000 - $200,000 = $225,000).
To be fair, this demonstrates the maximum amount a lender could issue, but other factors may come into play, including your employment history, income, and credit score.
What Can the Funds from a Home Equity Loan/HELOC Be Used For?
One of the benefits of home equity loans and HELOCs is the lack of restrictions on how you can use the funds. However, given that you collateralize your home to utilize these funds, it is worth it to exercise prudence and thoroughly consider how you should use the funds. Some examples of valuable ways to use these loans include:
Home Improvement, Renovations, and Repairs. Tapping into your home's existing equity to increase the value of your home is often an excellent use of home equity loans or HELOCs. Mainly because there are often unforeseen costs with construction, HELOCs are an easier way to tap into more funds as you need them. That said, some improvements add more value to your home than others. Generally, remodeling kitchens and bathrooms can increase your home's value, as well as finishing a basement or changing the house's exterior to increase curb appeal.
Medical Bills. Healthcare costs can add up quickly. There are many strategies to consider when you have significant medical bills. While utilizing home equity to pay for them is not the first strategy to consider, it can have lower interest rates than other financing options if you have no other alternatives than to borrow to meet those expenses.
Education. At Holzberg Wealth Management, we believe one of the best investments you can make is in education. Whether for yourself or a loved one, it can be a fantastic use of your time and money. While it can sometimes be helpful to use your home equity to pay for these expenses, again, there are other strategies out there. Exploring all your options for paying education costs is a must, and if the student can qualify for federal student loans, this will likely be a better option than a second mortgage.
Generally speaking, just as there are good ways to utilize funds from a second mortgage, there are also expenses where using the funds should be avoided. While it can be seen as convenient to purchase expensive nonessential items because you can tap into your home equity to afford them, this can be a slippery slope, creating added debt and strain on your budget. Moreover, you should not use these funds to invest in something risky, like the stock market or cryptocurrencies. It bears repeating that because you are collateralizing your home for these loans, you should have a strategy to use them as a wealth-building tool or for emergencies. Therefore, home equity loans and lines of credit are generally ill-advised to finance vacations or depreciating assets (such as vehicles). Also, there are most likely better strategies than this if you plan to sell your home in the near future. One of the predominant benefits of home equity loans and lines of credit is their extended borrowing and payment timelines. If you sell your home while repaying the loan, you must pay it off entirely at the time of sale.
Alternatives to Home Equity Loans/HELOCs
One notable alternative to tap into your home's equity without using a home equity loan or a HELOC is a cash-out refinance. This involves refinancing your current mortgage and taking out a new loan whereby you borrow more than you currently owe. It avoids the need to take out a second mortgage and instead replaces your existing mortgage with a new one. Consequently, the interest rates on cash-out refinances can be more attractive than home equity loans and HELOCs since they are a first mortgage and pose less risk for the lender. However, be advised that the interest rate on a cash-out refinance could be more than had you simply refinanced your mortgage for the amount you owe. In doing this, it allows you to take the additional cash from the cash-out refinance and use it however you need, or you could pocket the difference.
For example, let's say your home's value is $500,000, and you have a $300,000 balance on your mortgage. You could use a cash-out refinance to borrow up to $400,000. From there, you must use $300,000 to pay off the existing mortgage and then pocket the other $100,000. Remember, there are closing costs and other fees, which will be taken from the amount you pocket.
Like second mortgages, cash-out refinancing has its own credit score requirements. There is also a maximum loan-to-value you can borrow (usually 80-85%), and it requires you to be below a certain debt-to-income ratio (usually less than 40-50%). Moreover, since you are taking out a new first mortgage, closing costs tend to be much higher than home equity loans and lines of credit.
Personal loans are a way to borrow without digging into your home equity and using your home as collateral. You can utilize a secured personal loan that involves pledging some form of collateral, such as a savings account or CD, or an unsecured personal loan that is not backed by collateral. However, because unsecured personal loans are not backed by anything, lenders deem these to be riskier than secured loans, so you will likely have a higher interest rate with an unsecured loan than a secured loan. One example of an unsecured personal loan is a home improvement loan in which lenders provide a lump sum specifically to upgrade or repair your home. Lenders will write loans up to $100,000, which you repay in fixed monthly installments with terms ranging from two to 12 years.
How To Shop For a Home Equity Loan/HELOC
Before signing on any dotted lines, you should shop at different lenders to find the best deal. Contacting your current mortgage lender is often the best place to start, as they may offer you a competitive rate for already doing business with them. Asking friends and family for recommendations or mortgage brokers they work with or finding advertised rates online will also help.
Ask each lender to explain what options are available to you. Ask questions if you need clarification or help to understand any loan terms or conditions. You can also negotiate with more than one lender, asking them to meet or do better than the terms of other lenders. Also, read the loan closing documents carefully to ensure they reflect exactly what you expected. It could mean the difference in saving you money in the long run. Some critical areas to ask about include the following:
Annual Percentage Rate (APR). The most crucial factor to consider. The lower your rate, the lower the cost of your loan. This can be tricky with HELOCs because their rates are adjustable, but understanding the rates will make it easier to compare the loans side-by-side. Be careful to also consider points charged by the lender when comparing offers.
Balloon Payments. These usually come at the end of the loan and are often much larger than your regular monthly payment. It is a good idea to see if your loan terms indicate you will owe a balloon payment because if you cannot pay it when the time comes, you may need to refinance, which means starting the process again of paperwork and fees.
Prepayment Penalty. Some loans penalize you for paying off your loan early.
Credit Insurance. Some lenders may require you to purchase credit insurance which agrees to pay your loan if you become insolvent, disabled, unemployed, or pass away. Some individuals may already have protections in place if this occurs, whether it be through a life or disability insurance policy. If you do not want credit insurance, do not sign up for it. If it is automatically included in the loan and is optional, ask the lender to remove the fee.
The Three-Day Cancellation Rule
The three-day cancellation rule is a federally mandated law that says you have until midnight of the third business day after closing, including Saturdays but not Sundays or legal public holidays, to cancel a credit agreement that secures your principal residence without penalty. For example, if the closing happens on a Friday, you have until midnight on Tuesday to cancel.
To cancel the agreement, you must inform the lender in writing (you cannot cancel via phone or in a face-to-face conversation) of your intentions to cancel, and you must mail or deliver your written notice before midnight on the third business day.
NOTE: You can use this rule to cancel for any reason, but only if you pledge your primary residence as collateral for the loan – this rule does not apply to a vacation property or a second home.
To learn more about the three-day cancellation rule, take a look at this article from the Federal Trade Commission.
FAQs
Will the interest rate on my second mortgage be higher than my first mortgage?
How is the interest rate for a second mortgage determined?
Are second mortgages a good idea?
In Conclusion
If you are considering taking out a second mortgage, whether a home equity loan or a HELOC, it is essential to understand the differences between the two and assess what makes the most sense for you. Also, take the time to shop around and compare financing offered by different banks, credit unions, and mortgage companies. This will ensure you are getting the best terms and a better deal, which is paramount when the value of your home is securing your loan. If you already do business with a bank (maybe you have some existing accounts with them), ask if they have special promotions for existing customers. Also, talking to a mortgage broker (an individual who works with multiple lenders and essentially does the shopping around for you) can be a great place to look. It is a good idea to get quotes and compare rates, points, and fees from at least two or three lenders.
To reduce your risks when borrowing against your home, consider your options and your budget. It is a good idea to talk to someone you trust, like a financial advisor, if you have questions about whether these strategies make sense for you. You can schedule a complimentary, no-obligation call with us here!
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About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
** This writing is for informational purposes only. The author and Holzberg Wealth Management do not guarantee or otherwise promise any results that may be obtained from using this report. No reader should make any investment decision without first consulting their financial advisor and conducting their own research and due diligence. These commentaries, analyses, opinions, and recommendations represent the personal and subjective views of the author and do not constitute a recommendation, offer, or solicitation to make any securities transaction. The information provided in this report is obtained from sources that the author believes to be reliable. External links to third parties are being provided for informational purposes only. Holzberg Wealth Management is not affiliated with the third-party websites linked to, unless otherwise explicitly stated, and does not constitute an endorsement or approval by Holzberg Wealth Management of any of the third party’s products, services, or opinions.