Second Mortgage vs. Refinancing: What’s the Difference?

As a homeowner, you build equity every time you make a mortgage payment. Equity also grows as the value of your home increases. Home equity is valuable because you can borrow it in many different ways. If you’re considering taking out a second mortgage or refinancing your existing loan, it’s important to understand how each option works and the difference between them before you decide.

What Is a Second Mortgage?

A second mortgage is a loan taken out on a home that already has a mortgage. Like your first mortgage, it’s secured by your home equity, which is the difference between your home’s value in the current market and what you owe on it.

Second mortgages come with their own interest rates and repayment schedules, which means you must make payments on a second mortgage in addition to your primary mortgage payments. Interest rates on second mortgages are usually lower than those for credit cards or personal loans but higher than those on primary mortgages.

Second mortgages take second priority for repayment behind the primary mortgage in case of foreclosure. That means when foreclosed homes are sold, the proceeds are used to repay the full balance on the primary mortgage first, and then any remaining proceeds are used to pay off the second mortgage. That means the second mortgage lender is less likely to recoup its losses and often will charge the borrower higher interest rates to compensate for the increased risk.

Types of Second Mortgages

There are two main types of second mortgages: home equity lines of credit and home equity loans.

Home equity line of credit

Better known as a HELOC, a home equity line of credit lets you access a pool of money secured by your equity that you can borrow as needed.

Most HELOCs have a draw period and a repayment period. During the draw period — usually five to 10 years — you can withdraw money as needed from your HELOC, up to the loan limit. This generally works like a credit card, where the credit limit is the loan amount secured by your home equity. You make minimum payments on the loan during the draw period.

Once the draw period ends and the repayment period begins, you usually can no longer withdraw money and must begin repaying what you’ve borrowed — plus interest. Some lenders may require the balance to be paid in full at the end of the draw period.

HELOCs typically come with variable interest rates, meaning the loan’s interest rate will change according to market factors.

Home equity loan

A home equity loan pays out a lump sum of cash secured by your equity. It’s repaid in monthly installments, usually with a fixed interest rate. The repayment schedule on a home equity loan usually is between five and 20 years.

Unlike a HELOC, you can’t take out more money after receiving the lump sum, and the repayment period begins as soon as you take out the loan.

How Does a Second Mortgage Work?

Second mortgages work much like primary mortgages in terms of the loan application process and repayment terms. They have credit and minimum equity requirements — usually 20% — as well as possible closing costs. Your mortgage lender may cover some of these fees. Most lenders let you borrow up to 85% of your home equity with a second mortgage.

For example, if your home is worth $400,000 and you owe $300,000 on your mortgage, your equity is $100,000 — 25% of the home’s value. That means, if qualified, you could take out a home equity loan or set up a HELOC for as much as $85,000, which you could use to pay for significant expenses, such as home improvements, college tuition, or medical bills. You would make a monthly payment on your home equity loan or HELOC in addition to the monthly payment on your primary mortgage. If you borrowed the entire available amount, you would retain less than 4% equity in your home and may have to pay for private mortgage insurance, depending on your loan type.

Second Mortgage Requirements

Like your primary mortgage, secondary mortgages have requirements borrowers must meet to assure their lender they can repay the loan. Common requirements include:

• Minimum credit score. The minimum credit score for a second mortgage usually is around 620, though a higher score may earn you a better interest rate.
• Proof of income. Lenders likely will ask for recent pay stubs, tax forms, and proof of employment so they know you can afford the payments.
• Minimum equity. Lenders usually prefer you have at least 20% equity in your home to get a second mortgage. The more equity you have, the more cash you’ll be able to borrow.
• Maximum debt-to-income ratio. This figure measures how much of your gross monthly income is needed to pay the minimums on your debts. Our DTI ratio calculator can help you figure it out. Lenders typically require a DTI ratio no higher than 43%.

Pros and Cons of a Second Mortgage

While a second mortgage lets you borrow your equity as cash, it does come with trade-offs.

What Is Mortgage Refinancing?

Mortgage refinancing is when you take out a new mortgage to replace your existing home loan. This usually is done to get a lower interest rate or a different loan term. Homeowners also can refinance to borrow their equity with a cash-out refinance.

How Different Types of Refinances Work

When you refinance your mortgage, you’re applying for a new loan, so the requirements are similar to those for getting a mortgage to buy a home. You also need to pay refinance closing costs, which average $5,000.

Our mortgage refinance calculator can help you run the numbers.

Cash-out refinancing

A cash-out refinance pays off your current mortgage with a new loan based on your home’s current market value. You keep the difference between the amount you borrow and what you owe on your old mortgage as cash and repay it as part of the new loan.

Say you bought a $400,000 home with a 10% down payment and a 30-year fixed-rate mortgage for $360,000 at a 6% interest rate. After 10 years, your home’s value has increased to $500,000, and you’ve paid down your mortgage balance to about $300,000, giving you $200,000 in equity.

If you need to pay for home improvements or send someone to college, you could refinance to another 30-year fixed-rate mortgage for $400,000, leaving you with $100,000 in cash after repaying your original mortgage. The loan term would start over — so in addition to your monthly payment increasing, your loan payoff date would be moved 10 years into the future.

Rate-and-term refinancing

A rate-and-term refinance is when you replace your mortgage with a new mortgage that pays off your previous loan balance without borrowing any equity as cash. This allows you to adjust your interest rate and loan term, which can help you save money on interest or make your home more affordable in the long run.

Refinancing to remove PMI

If you made a down payment of less than 20% and bought your home using a conventional mortgage, you have to pay for PMI. If your home has increased in value enough to refinance with more than 20% equity, you can stop paying for PMI. This could save you money over the life of the loan, though keep in mind you have to pay closing costs to refinance.

Switching between fixed-rate and adjustable-rate loans

Refinancing from a fixed-rate mortgage to an adjustable-rate mortgage — or vice versa — is a strategic financial decision that should reflect your financial goals. The lower introductory interest rate on an ARM might be attractive if you expect market rates to fall or if you plan to sell the home before your rate is scheduled to adjust. Conversely, switching from an ARM to a fixed-rate mortgage locks in your monthly payment for the life of your loan — protecting you from rate increases.

Mortgage Refinancing Requirements

Refinancing involves applying for a new mortgage, which is similar to getting a home purchase loan. While specific requirements and necessary documents will differ by lender and loan type, there are some general criteria for refinancing your mortgage:

• Minimum credit score. Generally, conventional loans require a credit score of 620 or higher before you can refinance. Government-backed loans may have a lower minimum.
• Proof of income. Lenders will ask for proof of employment and income.
• Minimum equity. Lenders generally require you to have at least 20% equity to refinance.
• Maximum DTI ratio. Lenders usually require a debt-to-income ratio of 50% or less to refinance.
• Minimum time. Some cash-out refinances will have seasoning requirements, which means you’ll need to wait a while after refinancing before you can refinance again. For conventional loans, that time usually is six months.
• Closing costs. You’ll have to pay fees for an appraisal, underwriting, and other services when you refinance, meaning that you’ll need cash on hand.

Pros and Cons of Refinancing

While refinancing allows you to change some aspects of your loan, it also has drawbacks.

How To Decide Between a Second Mortgage and Refinancing

To decide between a second mortgage and refinancing, consider the overall cost. Also, consider how much you need to borrow, market interest rates, and how easily you can afford the new monthly payment.

“It is a good idea to take out a second mortgage rather than refinance when your first mortgage rate is so low that it would benefit you to keep that existing mortgage rate in place,” says Leisa Peterson, a financial planner and business strategist at WealthClinic in Sedona, Arizona. “On the other hand, refinancing is a good idea if you can save money both monthlyandover the lifetime of the loan compared to the loan you have currently.”

When does a second mortgage make sense?

A second mortgage can make sense when you want to access equity without altering your original mortgage terms. This option is particularly advantageous if your first mortgage has a low interest rate that you don’t want to lose, as it lets you borrow your equity without affecting your first mortgage.

When does refinancing make sense?

Refinancing can make sense when it lets you secure a lower interest rate than your current mortgage, which reduces your monthly payment and overall loan costs. It also makes sense if you want to change your loan’s term, either to pay off your mortgage faster with a shorter term or to lower monthly payments by extending the term.

FAQ: Second Mortgage vs. Refinancing

Here are the answers to some common questions about getting a second mortgage versus refinancing.

The Bottom Line on a Second Mortgage vs. Refinancing

Taking out a second mortgage can let you borrow cash without changing the terms of your first mortgage. That can let you keep your current interest rate, though you’ll have a second monthly payment to make. Refinancing, meanwhile, allows you to adjust your loan type, term, and interest rate — and repay any equity you borrow with a single monthly payment. It’s important to think through how each approach will affect your personal financial situation and your goals when deciding which is right for you.

Eric Rosenberg and T.J. Porter contributed to the reporting of this article.