What Is a Second Mortgage and When Is It a Good Idea?

Article Summary: What is a second mortgage and why do people use them? When is it a good idea to get a second mortgage, and when is it a bad idea? These are the questions we will address in this article.

A second mortgage is an installment loan or line of credit that uses your home as collateral. The amount you are able to borrow against your home is determined by the amount of equity (ownership) you have in your home. For example, your home is currently valued at $300,000 but your mortgage balance is only $200,000. This means you have $100,000 worth of equity, or ownership in the home.

Most lenders will loan you up to 80% of your available equity. They will secure their "interest" in your home by filing a lien behind the lender who loaned you the money for the actual purchase (first mortgage) of the home. This means that later on, when you sell the home, both the first and second mortgage will be paid off. Of course, you can also pay off the second mortgage anytime you are financially able to do so. You could also refinance down the road to roll the second and first mortgages together.

An installment version of the second mortgage is just like your first mortgage -- it is a set amount with a monthly payment until the balance is paid in full. This type of loan is typically used for a specific project, such as a swimming pool or a renovation project. The whole amount of the loan is advanced in chunks as the pool (or other project) is being built. Then, when the project is complete, you will start making payments on the second mortgage loan.

Reasons to Use a Second Mortgage

There are many reasons people take out a second mortgage on their home. They may use it to remodel their kitchen, pay for a new addition, or to put in a pool. Or perhaps they need to pay for college tuition for a child, or for the adoption of a child. They may use the second mortgage to pay for a wedding or a dream vacation.

Many people use the loan or line-of-credit to payoff bills and consolidate their debt. Regardless of the reasons, there are several advantages to using a second mortgage. For one thing, the interest paid on the loan or line-of-credit can be used as a deduction on most people's taxes. In addition, the interest rates on a second mortgage are usually lower than the rates for credit cards, student loans and other types of credit accounts.

In particular, homeowners who live in a strong real estate market with good appreciation can take advantage of their equity through the second mortgage option. This can be a good way to consolidate debt. Also, if you have lived in your home for many years and the value of your home will go up considerably with a kitchen or bathroom remodel, then a second mortgage might be a smart financing idea.

Reasons to Avoid It

With all of this being said, there are certain scenarios where it doesn't make sense to take out a second mortgage on your home.

The recent economic downturn we've seen is a prime example of this. Just before the housing bubble burst, homeowners were taking out second mortgages right and left. The value of their homes increased quickly and dramatically, so they were using their newfound equity to make all sorts of improvements -- additions, pools, remodels, etc. Many were even buying cars and second homes. Then, when the real estate bubble burst, they found themselves with over-improved homes and mortgage balances that were much higher than their home was now worth.

Here's what you should take away from this article. A second mortgage can be a useful financing tool in certain scenarios, because it allows you to leverage your home equity at a favorable interest rate. In other scenarios, however, this type of loan doesn't make sense. The key is to know what type of situation you are in, and decide for or against the second mortgage accordingly.