Second mortgages are loans that let homeowners borrow money using the equity in their homes. Most lenders offer two types of second mortgages: home equity loans and home equity lines of credit. Each loan has its own benefits and drawbacks, so homeowners must understand how they work before taking on additional debt. Here are some tips on second mortgages.

Second Mortgage Basics

A second mortgage is a separate loan that lets people obtain additional financing using the equity they have built in their homes. Equity is the current value of a home minus how much is owed. For example, if the current market value of a home is $200,000, and the homeowner owes $150,000, there is $50,000 in equity available.

Most lenders express equity as a percentage. In the example above, there is a 25 percent equity in the home ($150,000/$200,000 = 25 percent). In the mortgage industry, the homeowner would have a loan-to-value ratio (LTV) of 75 percent.

Most lenders only allow homeowners to borrow up to a certain percentage of the home’s current value for second mortgages. For example, some lenders have an 80 percent LTV threshold. So, if a homeowner’s current LTV is 75 percent (as in the example above), the maximum the lender would let the homeowner borrow as a second mortgage is 5 percent of the home’s value. However, some mortgage companies allow higher LTVs, such as 90 to 95 percent of the current market value.

Home Equity Loan vs. Line of Credit

Second mortgages include home equity loans and home equity lines of credit. Home equity loans let homeowners receive the proceeds from their second mortgage in one lump sum and repay it in monthly installments. Lines of credit allow borrowers to draw money from a pool of funds. Also known as HELOCs, lines of credit work in a similar way to credit cards.

Second mortgages have drawbacks. First, homeowners will have two monthly mortgage payments. Second, interest rates on second home loans have higher interest rates than primary mortgages. However, the rates on second mortgages are traditionally lower than credit cards.

The good news is home-owners can use the money from a second mortgage however they see fit. Home improvements, debt consolidation or paying for a child’s education is a shortlist of ways homeowners can use the money.