Second Mortgage vs. Refinance: A Complete Guide

Learn the pros and cons of these two options here.

A second mortgage and a refinance are two different loan options that allow you to access the equity in your home. However, they work differently, and the right one for you depends on your financial goals and situation.

This guide will explain the differences between refinance vs. second mortgage and will help you understand how to know which is right for you when you want to take advantage of the home equity you've earned.

Understanding Refinance vs. Second Mortgage

A second mortgage and a home loan refinance both allow you to tap into the equity in your home, but you'll want to select the best one based on your goals and current financial situation.

A second mortgage involves getting an additional mortgage loan that's also guaranteed by your home, along with your primary mortgage. Your primary mortgage isn't affected when you get a second mortgage. You use a new loan to access equity you've built in your home while continuing to pay down your regular (or first) mortgage.

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 VA, 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 topay off your current loan and get additional money for other things like debt consolidation.

If you just want to borrow some of your home equity without changing your current home loan, a second mortgage is right for you. If you want to modify your current loan for any reason, a cash out refinance is the right call.

What Is a Refinance?

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 now is 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 the interest rate you are paying and can qualify for a new loan at a lower rate.
• 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 loan to refinance, especially if you are doing a cash-out refinance. This means your home must be worth more than you are trying to borrow.

What Is a Second Mortgage?

A second mortgage is a second loan on your home, which also uses the equity in the house to guarantee the loan. If you get a second mortgage, you keep your current loan and don't make any changes to it. But you get another loan, or a second mortgage.

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

You could get your second mortgage from the same lender who closed your first mortgage, or from a different one. Regardless, you'd have two separate loans you are responsible for paying and would need to make two monthly payments.

Types of Second Mortgages

As you consider second mortgage pros and cons, it's important to realize that there are two different kinds of second mortgages and each has its own benefits and perks. The two types are home equity loans and home equity lines of credit.

Home Equity Loan

A home equity loan gets its name from the fact you're taking a loan to access your home equity.

Home equity loans work very similarly to your original first mortgage. You'll apply for a loan for a set amount, such as $50,000, and you will receive a lump sum payment when you close on your loan.

Your home equity loan will typically have a fixed rate, which means the rate and payment won't change over the life of the loan. You'll pay off the loan on a set schedule such as over 10 or 20 years. The interest rate on your home equity loan will likely be different (and higher) from your primary or first mortgage.

Your first mortgage will not change at all when you get your home equity loan.

Home Equity Line of Credit (HELOC)

A home equity line of credit is different from a home equity loan because you don't get a fixed lump sum payment up front. Instead, you're approved for a line of credit and then allowed to borrow up to a certain amount over time, and you can borrow more as you repay what you owe.

While this may sound complicated, essentially a HELOC works like a credit card. You get a maximum limit you can borrow, and can access the funds as you need them, continually repaying and then borrowing again during the life of the loan.

The big difference is that your house is guaranteeing this line of credit, so you usually pay a much lower interest rate than you would on a credit card. Of course, this means you could face foreclosure on your house if you don't make payments. HELOCs also have a strict start and end date for borrowing against your equity and then paying it back.

Home equity loans generally start with variable rates, although some lenders allow you to convert your loan to a fixed rate after the initial draw period is over. This is called a fixed-rate conversion option.

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 and perks, so you'll need to understand the differences to decide which is right for you.

Cash Out Refinance

A cash out refinance is a loan that allows you to take cash out of your home by tapping into your home's equity. In other words, you get a new larger loan to pay off your current home loan and give you some cash to accomplish your other goals.

There are many reasons to get a cash out refinance, including to pay for improving your home or to refinance credit cards (or other expensive high-interest debt) into a more affordable loan. You also get the benefit of changing your current loan terms, which is helpful if you can qualify for a new loan at a lower rate or want to convert an ARM to a fixed rate loan.

When you get a cash out refinance loan, you could get a conventional loan which means it is not backed or guaranteed by the government and has lower costs and less restrictions. But you also have other options including the following:

• FHA cash out refinance: An FHA cash out refinance is a loan backed by the Federal Housing Administration, which tends to be easier to qualify for given the government guarantee. You don't need a current FHA Loan to qualify but must meet FHA requirements to borrow.
• VA cash out refinance: A VA cash out refinance is backed by the Veterans Administration, making it easier to qualify for the refinance loan. You must be a qualifying military member (including surviving spouses) or veteran to be eligible.

Rate-And-Term Refinance

A rate-and-term refinance does not tap into equity in your home. You don't borrow more than you currently owe, so you don't get cash back. The entire purpose of a rate-and-term refinance is to change the terms of your current loan. You may do this to get a lower rate, change from an ARM to a fixed rate loan, or change your payoff time.

Like with a cash out refinance, there are different loan types (including lower-cost conventional loans with no government backing). You also have the option to use the following types of loans:

• FHA streamline refinance: If you have a current FHA Loan, a streamline refinance allows you to refinance to a new FHA Loan with better terms. There is less paperwork required than with a typical refinance and you may not need a home appraisal.
• VA IRRRL/streamline refinance: A VA streamline refinance also allows a faster and easier refinance loan. You can qualify for one if you currently have a VA Loan and a new mortgage lowers your rate or makes your loan more affordable.
• USDA streamline refinance: If you have a USDA loan, you could qualify for a USDA streamline refinance. This would again allow you to get a new loan with much less paperwork and more favorable borrowing terms.

Eligibility Requirements for Refinances vs. Second Mortgages

Whether you are 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. You need to understand what they are to make sure you can get the loan you're interested in.

Refinance Eligibility Criteria

Here are some of the typical requirements that lenders have in order to be eligible for a refinance loan:

• Debt-to-income ratio (DTI): 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, most lenders want you to have at least fair to good credit to get a refinance loan.
• Debt-to-income ratio (DTI): Lenders compare your debt to your income to make sure you have enough money to pay back your refinance loan. This can be especially important if you are increasing your loan amount. The required DTI for refinance varies by 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 loan-to-value ratio at 80% or 90% of what you owe. So, if your home is worth $500,000, you may only be allowed to borrow a maximum of 80% or 90% of that amount, so $400,000 to $450,000.
• 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. Some of those requirements may include:

• 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 insurance because the house is the collateral for the loan. They need to make sure there's money to pay off the debt or fix the home if something happens and the home is destroyed or damaged.
• DTI: DTI stands for debt-to-income ratio. The total amount of debt you have including your first and second mortgage and other money you owe, cannot exceed a specific percentage of your home. Each lender determines their maximum DTI ratio to borrow.

A mortgage specialist can help you to understand these requirements and ensure that you are eligible for the loan you are applying for.

How To Choose Between a Second Mortgage and Refinance

If you are deciding between a second mortgage and a refinance, there's one key question to ask yourself: Do you want to change the terms of your current loan?

• If you want to change your current mortgage, then refinance.
• If you don't want to change the terms of your current loan but just want to tap into your equity, get a second mortgage.

It's also worth noting that a second mortgage adds a second line or second note onto your home. This could make refinancing more complicated in the future since you would have a higher loan-to-value ratio after accounting for that second loan.

In other words, if you refinance, your lender needs to know that your combined loan value isn't too high relative to what your home's value.

Second Mortgage vs. Refinance FAQs

Here are the answers to some frequently asked questions about second mortgages vs. refinancing.

What Is the Difference Between Refinance and Second Mortgage?

A refinance is a new loan used to pay off your existing mortgage. You could do a cash out refinance to get equity out of your home or just refinance to change the terms of your current loan. Either way, you end up with one new loan with a new interest rate and terms.

A second mortgage, on the other hand, doesn't affect your current loan at all and is just used to access equity. You end up with two separate loans to pay and your first mortgage remains unchanged.

Is It Better to Refinance or Get a Second Mortgage?

Sometimes it is better to refinance and sometimes it is better to get a second mortgage, as each type of loan accomplishes different goals. It's better to refinance if you want to change the terms of your current loan, and it's better to get a second mortgage if you just want to get equity out of your home and you don't want your current mortgage impacted at all.

Does a Second Mortgage Affect My Current Loan?

A second mortgage does not affect your current loan. Your existing loan remains unchanged and you simply have two separate loans and two separate loan payments.

Second Mortgage vs. Refinance Closing Thoughts

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 with your lender to see which loan is right for you.