Looking for a way to free up some cash? (Of course you are!) One option is to take out a second mortgage on your home, which entails using your house as collateral to obtain another loan in addition to your first mortgage. It allows you to access the equity in your home, which is the difference between the balance of your original mortgage and the current value of your home (e.g., if your home is worth $250,000 and your mortgage balance is $200,000, you have $50,000 in home equity). Most mortgage lenders will allow you to borrow up to 80% of your home's equity (which for the above example would total $40,000).
Second mortgages are popular right now thanks to America's robust housing market, with median home prices hitting a record high of $239,700 in May -- up 4.7% year over year. So if you're one of those lucky ducks who's built up a large sum of equity in your home, getting a second mortgage is one way to boost your cash flow.
But there are some things you should know first.
You can spend the cash however you choose
There are no limitations on how you use the money from a second mortgage.
"Mortgage lenders aren't concerned by how you spend the cash," says Todd Sheinin, mortgage lender and chief operating officer at New America Financial in Gaithersburg, MD. "They're concerned about whether you'll be able to repay the debt on time."
Using the cash to finish the basement, for example, or build that much-needed addition to your home can pay off in the long term.
"If you're going to make improvements to the property that will increase its value, getting a second mortgage becomes a good investment," says Richard Redmond, mortgage broker at All California Mortgage in Larkspur and author of "Mortgages: The Insider's Guide."
Some people use the cash to send their kids to college, cover living expenses during a period of unemployment, or pay off large credit card debts -- all valid reasons to get a second mortgage, says Sheinin.
However, getting a second mortgage to fund discretionary spending -- like taking the family unit on a sweet Mediterranean cruise -- probably isn't the best financial decision.
"Don't look at your equity as free money," says Redmond. "You're essentially spending your savings when you take out a second mortgage, so you need to think very carefully about how you're going to use the money."
There are two types of second mortgages
You can opt for either a home equity loan or home equity line of credit (HELOC). A home equity loan provides you with the cash upfront, and you pay monthly installments over the length of the loan (like you do on your first mortgage). Consequently, "you immediately start paying interest on the loan," says Redmond. One advantage to a home equity loan is that it has a fixed interest rate.
A HELOC, meanwhile, has an adjustable interest rate -- meaning the rate can rise substantially if market indexes increase. But the key difference between a HELOC and a home equity loan is that you aren't provided the cash upfront. Instead, you have access to the full amount of the loan through a line of credit, but pay interest only on the cash that you borrow. "A [HELOC] is like having a big credit card attached to your home," Sheinin explains.
Given that they offer greater flexibility, HELOCs are more commonly used than home equity loans, but which one you opt for depends on what you really need: a sizable chunk all at once, or small injections of cash on a regular basis?
Second mortgages typically have higher interest rates and fees
When you apply for a second mortgage, lenders look to see if you meet the necessary credit and income requirements. It's essentially the same application process you went through for your first home loan, but second mortgage interest rates and fees are usually higher because the second mortgage lender is assuming more risk. If you default on the home and the property goes into foreclosure, the first loan takes priority -- meaning the second lender may not receive any or all of the proceeds from the foreclosure sale.
So before applying for a second mortgage, consider the costs of opening and maintaining the loan -- including application fees, home appraisal fees, closing costs (3% to 6% of the loan amount), and annual fees.
Also keep in mind that these fees are sometimes negotiable, so it pays to ask the mortgage lender what kind of wiggle room they may have.
You don't need to use your first mortgage lender
You can choose a new lender for your second mortgage if you prefer. Therefore, you'll want to shop around to find the best interest rate. Obtain quotes from at least three lenders and make sure the loan terms are identical so you're getting an apples-to-apples comparison. Some lenders are more open to waiving certain nominal fees than others.