Second Mortgage vs. Refinance: Which Is Right For You?

What Is a Second Mortgage and How Does It Work?

A second mortgage is an additional loan that uses your home as collateral. Your existing mortgage doesn’t change, maintaining the same interest rate and terms.

You can qualify for a second mortgage only if you have enough equity to guarantee both loans. In most cases, lenders allow you to borrow a total of around 80% to 90% of the market value of your house across both mortgages.

You could get your second mortgage from the same lender who closed your first mortgage, or from a different lender. Whichever you choose, you’d have two separate loans with separate monthly payments.

Types of Second Mortgages

As you consider the pros and cons of a second mortgage, it’s important to realize that there are two different kinds of second mortgages, and each has its own benefits.

• Home equity line of credit: A home equity line of credit (HELOC) is a loan secured by your home that provides an approved credit limit. With Freedom Mortgage's HELOC, the full amount is distributed to you at closing, and any funds you repay become available again for a later draw, with the rate on that new draw set at the time it is made. 
• Home equity loan: A home equity loan provides access to your home equity, and it works similarly to a first mortgage. You apply with a set amount in mind and receive a lump sum payment when you close on your loan. It will have a fixed rate to repay, and it will be over a set period of time and you may not access the funds you’ve repaid.

Second Mortgage Example

A homeowner may take out a second mortgage to access a portion of their equity if, for example, they have $80,000 worth of equity in a $200,000 home. They can apply for a second mortgage to access part of it, though most lenders prefer that homeowners keep at least 10%-20% equity in their homes depending on loan type and financial situation. In this example, the homeowner might be able to take out between $40,000 and $60,000 through a second mortgage, depending on the lender's maximum combined loan-to-value limit. They can use these funds to pay down higher-interest debt, purchase home improvements, send a child to college, or just about anything else the homeowner needs an influx of cash for. 

A second mortgage is a new loan alongside the first mortgage It must be paid off separately and has its own interest rate, balance and monthly payment. The exact terms will depend on the lender and how much equity a homeowner has in their home.  

What Is a Mortgage Refinance and How Does It Work?

A mortgage refinance involves getting a new loan to repay your existing mortgage. You could do this for many reasons, including changing the terms of your loan or changing the type of mortgage on your home (from FHA to conventional, for example). If you want to tap into your home’s equity (take cash out of the home), your new refinance loan would be for more than you currently owe. This allows you to pay off your current loan and get additional money for other things like debt consolidation. By refinancing, the total finance charges may be higher over the life of the loan.

Types of Refinances

Just as there are different kinds of second mortgages, there are also different kinds of refinances, including a cash out refinance and a rate-and-term refinance. Each has its own benefits.

• Cash out refinance: A cash out refinance is a loan that lets you take cash out of your home through equity and replaces your original home loan. This allows you to change your loan terms and potentially access a more affordable loan rate or pay off other high interest debt. By refinancing, the total finance charges may be higher over the life of the loan.
• Rate-and-term refinance: A rate-and-term refinance does not give you access to equity, so you don’t get cash back. Instead, it allows you to change the terms of your current loan, adjusting interest rates, loan type, or the duration of the loan. By refinancing, the total finance charges may be higher over the life of the loan.

Depending on your situation, you may also have access to government-backed refinance options. Most homeowners can refinance through a FHA cash out refinance to get access to equity or FHA streamline refinance to change their loan terms. Veterans, active-duty military, and other eligible borrowers have access to VA cash out refinances and VA streamline (IRRRL) refinances to provide more opportunities for home refinancing.  

Mortgage Refinance Examples

Here’s a quick example of how a mortgage refinance works. You’re a homeowner with a home worth $400,000 and with a $300,000 mortgage from Bank A. You decide to refinance to a different loan from Bank B. You borrow the money from Bank B to pay off your loan to Bank A. Bank B is now your mortgage lender, and you pay the loan back over the agreed-upon rate and term of your new mortgage.

Refinancing allows you to change the terms of your loan or to access equity. It can make sense to refinance if:

• You want to get cash out of your home using a cash out refinance. This would mean borrowing more than you currently owe and receiving a lump sum at closing.
• You want to reduce your current interest rate and can qualify for a new loan at a lower rate. By refinancing, the total finance charges may be higher over the life of the loan.
• You want to change your loan term, such as switching from a 30-year mortgage to a 15-year mortgage to repay your loan faster.
• You want to change the type of loan, such as converting from an adjustable-rate mortgage (ARM), with a rate that can change over time, to a fixed-rate mortgage, with a rate that stays the same for the life of the loan.

You need to have enough equity in your home to refinance, especially if you’re doing a cash out refinance. This means your home must be worth more than the amount you’re trying to borrow.

How to Choose Between a Second Mortgage and Refinance

If you’re deciding between a second mortgage and a refinance, consider your financial goals. There are pros and cons to both options, and by fully understanding them, you can make an informed decision about what route is best for you. 

Mortgage Refinance Pros and Cons 

Mortgage refinances allow you to change the terms of your current loan, potentially giving access to additional funds. By refinancing, the total finance charges may be higher over the life of the loan. 

Second Mortgage Pros and Cons

Taking out a second mortgage allows access to equity without changing the terms of your first loan, providing unique benefits.

Eligibility Requirements for Refinances vs. Second Mortgages

Whether you’re applying for a refinance or a second mortgage, you must meet your lender’s requirements to qualify for the new loan. Although the specific eligibility rules vary by loan type and lender, there are certain things that all lenders look for when deciding whether to give you a loan.

Refinance Eligibility Criteria

Here are some of the typical refinance requirements that lenders have for refinance loans:

• Credit Score: Lenders want to make sure you’ve been responsible with borrowing in the past and can afford a new mortgage payment. Your credit score helps them figure this out. While minimum required scores vary by loan type and lender, most conventional refinance programs require a score in the 600s for most borrowers while government backed refinance loans are often available with scores in the 500s.
• Debt-to-income ratio (DTI): Lenders compare your debt to your income as part of the underwriting process. A higher DTI may indicate a borrower’s budget is stretched too thin. This can be especially important if you are increasing your loan amount. The required DTI for a refinance varies by loan type and lender, and the debt counted includes your new mortgage loan plus everything else you owe (such as car payments and credit card bills).
• Loan-to-value (LTV): You must have enough equity in your home to refinance. Many lenders cap your cash out refi loan-to-value ratio (LTV) at 80% to 90% of your home’s current value, though limits vary by loan type; for example, government-backed programs such as VA cash out refinances may allow a higher LTV. So, if your home is worth $500,000, you may only be allowed to borrow up to $400,000 to $450,000 under an 80%-90% LTV limit, though the amount available may be higher or lower depending on your lender and the specific loan program you select.
• Homeowners insurance: You need insurance to protect your home because your home acts as collateral guaranteeing the loan.

Second Mortgage Eligibility Criteria

There are also certain eligibility requirements you must fulfill if you want to get a second mortgage, such as: 

• Home equity and an appraisal: In addition to the minimum required equity for a refinance, most lenders require an appraisal for a second mortgage. This determines exactly what your home’s market value is and how much equity you have.
• Homeowners insurance: Lenders want proof of homeowners insurance because the house is the collateral for the loan. They need to make sure there’s money to pay off the debt or to fix the home if something happens and it's destroyed or damaged.
• DTI: The total amount of debt you have, including your first and second mortgage and other money you owe, can’t exceed a specific percentage of your income. Each lender sets its maximum debt-to-income ratio (DTI) for borrowing.

A mortgage specialist can help you understand these requirements and guide you to loan options well suited to your needs and circumstances.

Final Thoughts: Second Mortgage vs. Refinance

Both a second mortgage and a refinance loan can help you accomplish important goals, such as accessing equity in your home to help you become debt-free or to remodel your house. When deciding between the two loan options, consider what your financial goals are for the loan. Be sure to explore both options and get prequalified to see which loan is right for you.