You gain equity in your home as you pay down your balance and the home appreciates in value. Using either a second mortgage or a cash-out refinance, you can borrow against this equity to fund projects such as home repairs or remodeling.
But which is best? Like most financial questions, it depends on your needs and specific situation.
What Is a Second Mortgage?
Getting a second mortgage involves taking out a new loan against your home’s equity. Second mortgages fall into two categories, and the type you use determines how the cash is paid out:
- Home equity loans: Home equity loans are paid out in a lump-sum amount that you pay back in monthly installments with a fixed interest rate.
- Home equity lines of credit (HELOCs): Rather than pay out your loan all at once, HELOCs come with a draw period during which you can continually access funds and spend up to your credit limit. You will only pay interest rates, which are variable, during the draw period, with monthly payments toward the remaining balance beginning after the draw period ends.
Whether you choose a home equity loan or a HELOC, you will still have to continue paying your primary mortgage payments as well. That means that if your original mortgage and your second mortgage are from different lenders, you’ll have to pay each company individually.
Keep in mind that a second mortgage comes with a second lien on your property, the lender of your original mortgage having the first lien. Because the primary lender gets paid back first in the case of foreclosure, the second lender takes on more risk, and second mortgages have higher interest rates than primary mortgages as a consequence. You may also be more likely to lose your home if you experience financial hardship and have a second mortgage, so make sure that you’ll be able to make both payments
Benefits of Taking Out a Second Mortgage
Benefits of taking out a second mortgage include:
- The choice of how your money is paid out: Choose a home equity loan if you want a lump sum payment and a HELOC if you want a credit line, which is ideal if you need funds for an ongoing project but aren’t sure exactly how much you’ll require. Refinancing doesn’t give you this choice.
- Fewer closing costs: Second mortgage loan providers usually cover most or even all of your closing costs, potentially saving you thousands of dollars.
- The ability to retain your current mortgage terms: Because second mortgages add an additional payment instead of replacing your primary loan, you get to keep your current loan terms. This is ideal if you have a great interest rate or rates have increased since you got your first mortgage.
Drawbacks of Taking Out a Second Mortgage
Drawbacks of taking out a second mortgage include:
- An extra monthly payment: You’ll now have two monthly payments to worry about, and missing one could mean losing your home.
- A second lien on your home: Having an additional lien on your home increases your risk of foreclosure in the case that you default.
- Inability to change your current mortgage terms: Because your second mortgage doesn’t impact your original loan, you can’t change your interest rate or term.
What Is a Cash-Out Refinance?
When you refinance, you replace your existing mortgage loan with a brand-new loan that pays off your remaining balance. Homeowners often choose to refinance in order to change the length of their repayment term or get a lower interest rate (called a “rate-and-term refinance”), but you can also withdraw cash against the equity in your home with a cash-out refinance.
Cash-out refinancing involves taking out a new loan equal to the amount of cash you want to withdraw plus the remaining balance. For instance, say that you want to borrow $20,000 for a remodeling project and you still owe $100,000 on your home. You could refinance into a loan of $120,000 and get the $20,000 in cash — that is, assuming that you’ve gained enough equity in your home.
Benefits of Cash-Out Refinance
Benefits of cash-out refinance include:
- A single monthly mortgage payment: You don’t have to worry about two monthly payments because your refinance loan completely replaces your original loan.
- The ability to change your rate and term: Not happy with your current mortgage’s rate or term? You have the option to change them when you refinance.
- Less risk for the lender: Your lender is faced with less risk because there’s only one lien on your property, which could translate into a lower interest rate.
Drawbacks of Cash-Out Refinance
Drawbacks of cash-out refinance include:
- Potentially higher closing costs: No one is going to cover your closing costs when you refinance — they’re your responsibility, so be prepared to shell out 2 to 3% of your loan’s total value at closing.
- Potential requirement to change your interest rate: Your lender may want you to accept an interest rate that’s closer to current rates, in which case you could lose money if your original rate was lower.
[Related: Guide to Closing Costs in Washington State]
Is a Second Mortgage or Cash-Out Refinance Best for Me?
Still not sure whether a second mortgage or cash-out refinance is best for you? Let’s walk through it one more time.
First, neither a second mortgage nor a cash-out refinance will allow you to access all of your home’s equity. Lenders usually only allow you to take out 90% of it, although that depends on the lender, your current debt, your credit score, and other factors.
Cash-out refinancing is likely the best option if interest rates have decreased since you took out your loan, since you can get a lower rate on your entire mortgage. However, you’ll have to have cash saved up for closing costs.
On the other hand, if interest rates have increased, it doesn’t make sense to refinance your entire loan at a higher rate — a smaller second mortgage is likely smarter. Second mortgages also give you the choice of how your loan is paid out and generally come with lower closing costs.
Consider your specific financial situation and weigh your options. At the end of the day, the only way to be sure you’re making the best decision is to work with an experienced mortgage lender who can run the numbers with confidence, like Seattle Mortgage Planners. Feel free to schedule a quick phone consultation with us to learn more.