The national average of homeowners with home equity of 30% or more stood at 83.3% in Q1 2023. Increased home equity enables homeowners to consider further financing options.
Two of the most common options to borrow funds using your home equity are a second mortgage and refinance. While both options can provide financial flexibility, their purpose, process, and outcome differ.
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📌Second Mortgage VS. REFINANCE
- As of January 2024, the average 30-year and 15-year fixed mortgage APR for refinance is 6.17% and 5.34%, respectively.
- Refinancing has costs associated with it, these costs amount to around 6% of the total loan amount.
- Second mortgages have lower interest rates than credit cards and personal loans. Moreover, the interest paid on a second mortgage is tax deductible.
What Is a Second Mortgage?
A second mortgage is a loan that you take out against your home equity. You can use the funds from a second mortgage for various purposes, such as home improvements, and debt consolidation.
Furthermore, the second mortgage is in addition to the first one and has its own terms and interest rate. If the homeowner defaults on the loans, the first mortgage takes priority in terms of repayment.
Types of Second Mortgages
There are two main types of second mortgages:
- Home Equity Loan: A home equity loan allows homeowners to borrow based on the equity they have built in their property. Borrowers receive the loan amount upfront and make regular monthly payments.
- Home Equity Line of Credit (HELOC): A HELOC functions more like a credit card. It gives homeowners a line of credit they can draw from as needed.
It’s important to assess your financial needs and consider the terms, costs, and potential risks of each option before opting for your home loan.
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Pros and Cons of Second Mortgages
It’s essential to carefully consider the pros and cons of second mortgage, and assess your financial situation:
✅ Pros
- Access to Funds: A second mortgage provides homeowners with the option to access funds by leveraging the equity in their property.
- Potentially Lower Interest Rates: Second mortgages have lower interest rates compared to personal loans or credit cards, making them a cost-effective option.
- Tax Advantages: In some instances, the interest paid on a second mortgage may be tax-deductible and decrease the overall cost of borrowing.
- Flexibility: Home equity loans and HELOCs offer flexibility in terms of borrowing and repayment. This allows homeowners to draw funds as needed.
❌ Cons
- Increased Debt Burden: A second mortgage adds another debt obligation on top of the existing mortgage. This will add to your monthly expenses and financial strain.
- Risk of Foreclosure: If homeowners are unable to make payments on both the first and second mortgages, they risk foreclosure. In the event of a default, the first mortgage takes priority.
- Costs and Fees: Second mortgages come with closing costs, origination fees, and other associated expenses, which add to the overall cost of borrowing.
- Potential Loss of Equity: By leveraging the equity in their property, homeowners may reduce the equity stake they have built up. Also, this impacts their ability to access the equity in the future or sell the property.
What Is Refinancing?
Refinancing refers to replacing an existing mortgage with a new one. The main intent behind refinancing is to obtain better terms, lower interest rates, or modify the loan structure.
Furthermore, the new loan terms, including the interest rate, repayment period, and monthly payments, are based on the homeowner’s financial situation at the time of refinancing.
Types of Refinancing
There are several types of refinancing options available to homeowners. Here are some common types:
- Rate-and-Term Refinance: Here the goal is to reduce monthly payments, shorten or extend the loan term, or switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa.
- Cash-Out Refinance: A cash-out refinance allows homeowners to tap into their home equity for purposes such as home improvements or debt consolidation.
- Cash-In Refinance: In a cash-in refinance, refinancing is done to lower the loan-to-value ratio (LTV), secure better interest rates, or remove private mortgage insurance (PMI) requirements.
- Streamline Refinance: Streamline refinancing is available for homeowners with certain types of government-backed loans, such as FHA (Federal Housing Administration) or VA (Department of Veterans Affairs) loans.
Moreover, streamlined refinancing aims to simplify the process by reducing documentation requirements and potentially lowering closing costs.
Pros and Cons of Refinancing
Before refinancing, homeowners should carefully evaluate the costs, potential savings, and their long-term financial goals.
✅ Pros
- Lower Interest Rates: Refinancing allows homeowners to take advantage of lower interest rates. It reduces your monthly mortgage payments and overall interest costs over the life of the loan.
- Access to Equity: Homeowners can tap into their home equity through a cash-out refinance. It provides funds for home improvements, debt consolidation, or other major expenses.
- Change in Loan Term: Refinancing can allow homeowners to shorten the loan term. It enables you to pay off your mortgage faster and build equity more quickly. Moreover, it can extend the loan term, reducing monthly payments and improving cash flow.
- Switching Loan Type: Refinancing allows switching from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage (FRM). This provides you stability and predictability in monthly payments.
❌ Cons
- Closing Costs: Refinancing typically involves closing costs, including application fees, origination fees, and appraisal fees. These costs can offset the potential savings from refinancing and may take time to recoup.
- Resetting the Loan Term: Refinancing often resets the loan term, meaning homeowners start over with a new mortgage and a new repayment period.
- Qualification Requirements: Refinancing requires meeting specific eligibility criteria, including credit score, income verification, and equity in the property.
- Potential Loss of Benefits: Refinancing may result in the loss of certain benefits associated with the original mortgage, such as interest rate deductions on taxes.
Is It Better to Get a Second Mortgage or Refinance?
Determining whether it’s better to get a second mortgage or refinance depends on your specific financial situation, goals, and needs. Here are some factors to consider:
Purpose of the Funds
Evaluate why you need the additional funds. If you have a specific one-time expense, a second mortgage may be suitable as it provides a lump sum.
Refinancing, on the other hand, can be beneficial if your primary goal is to obtain better terms, lower interest rates, or change your loan structure.
Interest Rates and Loan Terms
Compare the interest rates and loan terms available for both options. If you can secure a significantly lower interest rate through refinancing, it may lead to overall savings on interest costs.
However, if the interest rates on second mortgages are more favorable or if you have a low-interest first mortgage, a second mortgage might be a better choice.
Equity and Loan-To-Value Ratio
Assess the equity in your home and the loan-to-value (LTV) ratio. If you have substantial equity, a second mortgage may be easier to obtain and may offer more flexibility.
Refinancing may require meeting stricter LTV ratio requirements, particularly if you’re aiming for a cash-out refinance.
Costs and Fees
Consider the costs and fees associated with each option. Refinancing typically involves closing costs, such as appraisal fees, application fees, and origination fees.
A second mortgage may also have similar fees. Evaluate the potential savings versus the expenses to determine which option is more cost-effective.
Long-Term Financial Goals
Consider your long-term financial goals and how each option aligns with them. If your goal is to pay off your mortgage faster, refinancing to a shorter loan term might be more beneficial.
If your goal is to access funds for investments or other financial purposes, a second mortgage may be more suitable.
Bottom Line
Whether it’s better to get a second mortgage or refinance depends on your specific circumstances and goals.
A second mortgage may be more suitable if you have a specific one-time expense and favorable interest rates. Whereas, refinancing may be a better option if you want to improve loan terms, lower interest rates, or change the loan structure.
Additionally, evaluate the costs and fees associated with each option and consider how they align with your long-term financial goals.
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Frequently Asked Questions
Can I get a second mortgage if I already have an existing mortgage?
Yes, you can get a second mortgage even if you have an existing mortgage. It will be an additional loan that is secured by the equity in your property.
Will getting a second mortgage or refinancing affect my credit score?
Both second mortgage and refinancing can potentially impact on your credit score. When you apply for a new loan, the lender will typically perform a hard inquiry on your credit. The enquiry can cause a slight temporary decrease in your credit score.
Can you refinance a first and second mortgage together
Yes, borrowers may choose to use a cash-out refinance to combine their remaining first mortgage balance with their second mortgages. This can be done by rolling both debts into one new loan.
