Finance

Second Mortgage vs Refinancing: What’s Best for You?

August 30, 2023

Homeowners hoping to rework the terms of their current mortgage have a few routes to choose from. If you have significant equity in your home, lenders may be quick to approve you for one of several kinds of property-secured loans that can alter your repayment conditions.

Second mortgages and refinances are two common options that can help homeowners borrow against their equity and restructure their debt. While both are backed by your home, they have specific terms and conditions that gear them toward different scenarios.

If you’re trying to decide between a second mortgage vs refinancing, it’s best to understand their various intricacies. To help you make an informed decision, we’re breaking down their general terms, their pros and cons, and the types of situations each is best suited for.

What is a Second Mortgage?

A second mortgage is an extra mortgage added on top of your existing mortgage. Unlike cash out refinancing, which pays off your original mortgage before starting another one anew, borrowers are responsible for repaying both loans.

Much like first mortgages, second mortgages have principals, interest, and repayment terms. They’re generally paid out in large lump sums, then subsequently paid back by the borrower in monthly installments.

Interest rates can be fixed or variable, though they’re more likely to be fixed than first mortgages.

Pros and Cons of a Second Mortgage

Second mortgages present viable borrowing options when homeowners need quick money. They boast a few advantages versus other types of property-secured loans, including:

Multiple borrowing options – There’s more than one way to take out a second mortgage on your home. Home equity loans and Home Equity Lines of Credit (HELOCs) are two popular borrowing options for second mortgages. Curious about the difference between a HELOC and a home equity loan vs second mortgage? A home equity loan pays lump sums upfront, while a home equity line of credit allows you to withdraw cash as you need it, up to a certain limit.
Lower interest than other types of loans – While the interest on second mortgages is generally higher than on first mortgages, it’s still usually lower than the rates charged for other types of personal loans, such as credit cards.

Potential tax-deductibility – If you use the funds from a second mortgage loan to make renovations to your home, there’s a chance it could be tax deductible. The Tax Cuts and Jobs Act of 2017 allows homeowners to write off up to $750,000 in taxes on property-secured loans—if they use the money to make significant improvements to the property it’s borrowed against.

Despite these upsides, however, there are also significant drawbacks to taking out a second mortgage. If you’re considering one, know that they can entail:

Stringent lending qualifications – The financial requirements for taking out a second mortgage are generally more rigorous than first mortgages. Usually, borrowers need a credit score of 620, a debt-to-income (DTI) ratio of 43% or lower, and relatively high equity in their homes. Learn more about how to lower your debt-to-income ratio if you find yourself in this situation.

Higher interest rates than other property-secured loans – While the interest on second mortgages may be lower than that on unsecured debt, it’s also generally higher than rates on first mortgages. In the event of a default, the proceeds from property liquidation go to paying off the primary mortgage before the second gets a dime. Thus, lenders mitigate this increased risk by charging higher interest on second mortgages.

Appraisals and waiting periods – When seeking a second mortgage loan, homeowners must obtain a professional property appraisal at their own expense. This helps lenders determine their equity and whether or not they want to lend to them. However, such services are costly and can extend the loan processing period by a month or more.

The potential to lose your home – If you fail to meet the obligations of either of your mortgages, lenders may have the right to foreclose on your home. When you have multiple debts to deal with, monthly payments are generally steep, and the potential to default grows higher.

What is Refinancing?

Refinancing, while often considered in regard to mortgages, is the reworking and revising of any ongoing debt agreement.

Generally, homeowners seek out refinances to continue their existing mortgage on more favorable terms. There are different types of mortgage refinance options homeowners can explore. In order to obtain refinancing, borrowers must apply to their lender or financial institution in much the same way they did for their original home loan.

Often, borrowers will pursue refinancing options when changes to the real estate market and economy make it reasonable for them to do so. When average Annual Percentage Rates (APR) drop, for instance, homeowners may consider seeking out a refinancing to lower the interest they pay on their mortgage.

Pros and Cons of Refinancing

To better understand if this is the right option, it’s best to explore the pros and cons of refinancing. In some situations, refinancing can be a useful financial tool that can work in the homeowner’s favor. Some key advantages of mortgage refinance include:

The potential to lower interest – The main reason most borrowers seek out refinancing is to pay less interest. If rates drop and your lender agrees to a more favorable loan structure, refinancing can save you a lot of money over the course of your mortgage.

The chance to own your home sooner – Sometimes, homeowners will seek out refinancing because of changes in their own economic situation. If you recently received a pay bump, for instance, and can afford higher monthly installments, lenders may be willing to reduce your interest rate and the overall length of your mortgage loan term—allowing you to own your home sooner and for less money.

Of course, refinancing isn’t all positive for the homeowner. Some of the most glaring downsides include:

The potential to extend your mortgage – While some refinance agreements might help homeowners pay off their debts quicker, others may extend your mortgage’s repayment period and loan term in exchange for a lower interest rate. And this may cost you more in the long run.

Missing out on reduced interest with variable rates – Generally, borrowers sign up for fixed interest rates when they receive a refinancing. If rates drop, however, you’ll be paying more than you would have had you chosen a variable interest plan.

The chance of losing your home – Like all property-secured loans, defaulting on your refinanced mortgage can result in the lender claiming their collateral (i.e. your home). If you refinance your mortgage in response to increased economic means, but suddenly find yourself in hard times, issues could arise if you fall behind on payments.

Comparing Second Mortgage and Refinancing

Both second mortgages and refinancing involve either reworking the terms of your current mortgage or taking on a new loan. They’re both viable means of restructuring debt, though their specificities are slightly different.

Second mortgages, for instance:

Are added on in addition to your original mortgage, meaning borrowers are responsible for repaying both debts
Generally result in higher interest, as lenders incur more risk when approving them
Give borrowers a large lump sum that they can use for whatever they need or desire

Alternatively, refinancing generally results in:

A new lending agreement that supersedes and replaces your original mortgage
More favorable terms and conditions for the borrower
Fixed interest rates that, hopefully, will save the borrower money over the course of their agreement

One common issue for both of these types of loans, however, is their potential to result in foreclosure. Both types of loans generally mean higher monthly installments for homeowners, so be aware of your financial capabilities before applying for either.

Residential Sale-Leaseback: A Different Option

Perhaps you’re seeking a second mortgage because you need a large sum of cash, or maybe you’re pursuing refinancing because you don’t like the terms of your current agreement.

If so, there’s an effective alternative that doesn’t involve extending payment plans or the potential to lose your property.

Residential sale-leaseback agreements are a common form of real estate contract that allow you to convert your home equity and eliminate your need to pay a mortgage. In essence, homeowners sell their property to a buyer who agrees to rent it back to them afterward.

Residential sale-leaseback agreements can net you your home’s full value, rather than the percentage lenders are willing to risk based on your equity and history. That money can then be used in whatever way you see fit—with no lenders, principals, or monthly payment plans to worry about.

Which is Best for You?

If you’re trying to choose between a second mortgage and refinancing, it’s imperative to assess your own situation to see what fits it best.

If you have decent equity, credit, and a favorable DTI ratio, but are in need of quick cash, a second mortgage might be the right choice for you. If the money is put towards a profitable investment or worthy cause, such as your or your child’s education, it could be a solid financial move.

Alternatively, if your financial situation has recently improved and you can afford increased payments on your mortgage, you might consider pursuing refinancing. If you’re secure in your career and foresee prosperity for years to come, higher monthly installments can be your key to owning outright in less time.

Of course, if neither fits your situation, a residential sale-leaseback agreement might be another route to consider.

Key Takeaways

Both second mortgages and refinancing can help you restructure your current debt. Generally, people pursue second mortgages when they’re in need of a lump sum of cash. Refinancing, on the other hand, is more often used as a financial tool to help homeowners rewrite the terms of their existing agreement.

Both are secured using your property as collateral, so be careful when applying for either, as your home will be on the line.

Alternatively, if you want to convert your home’s equity without using your home as collateral, consider a residential sale-leaseback agreement rather than a second mortgage and refinancing.

Sources:

Twin, Alexandra. “Second Mortgage: What It Is, How It Works, Lender Requirements.” Investopedia. May 16, 2023. https://www.investopedia.com/terms/s/secondmortgage.asp
Chen, James. “Cash-Out Refinancing Explained: How It Works and When to Do It.” Investopedia. May 26, 2022. https://www.investopedia.com/terms/c/cashout_refinance.asp
Kagan, Julia. “What Is a First Mortgage? Definition, Requirements, and Example.” Investopedia. March 14, 2022. https://www.investopedia.com/terms/f/first_mortgage.asp
Kagan, Julia. “How a Home Equity Loan Works, Rates, Requirements & Calculator.” Investopedia. February 13, 2023. https://www.investopedia.com/terms/h/homeequityloan.asp
Kurt, Daniel. “HELOC (Home Equity Line of Credit) and Home Equity Loan: Comparing Your Options.” Investopedia. April 19, 2023. https://www.investopedia.com/home-equity-line-of-credit-heloc-definition-5217473
Twin, Alexandra. “Refinance: What It Is, How It Works, Types, and Example.” Investopedia. May 16, 2023. https://www.investopedia.com/terms/r/refinance.asp