The 2% rule states that you should aim for a 2% lower interest rate in order to ensure that the savings generated by your new loan will offset the cost refinancing, provided you've lived in your home for two years and plan to stay for at least two more.
Anisha Sekar of NerdWallet specifies that using a second mortgage makes the most sense in instances where the debt carries a higher interest rate than the home equity loan or home equity line.
Financial Security: Paying off your first mortgage eliminates a significant debt, providing you with increased financial security and peace of mind. Interest Savings: By paying off your mortgage early, you save money on interest payments over the life of the loan, which could amount to substantial savings.
Risk of foreclosure
This is one of the biggest risks of second mortgages. With a second mortgage, you're using your home as collateral. That means if you don't make your payments, your lender can foreclose on your house to pay off the balance.
Second mortgages have the same payment each month and give you a lump sum at the start of the loan, which you could use to pay off some or all of your mortgage.
If you take out a $50,000 home equity loan, you will receive all of the money at once and pay interest on the full amount. With a HELOC, you can withdraw money whenever you need it.
On your primary mortgage, you might be able to put as little as 5% down, depending on your credit score and other factors. On a second home, however, you will likely need to put down at least 10%.
Generally Best to Pay Off Highest Interest Rate First
Let's consider an example. If you've got a first mortgage with an interest rate of 6%, and a second mortgage set at 12%, it'd probably be in your best interest to knock out that second mortgage sooner rather than later.
Impact on Credit Score
Applying for a second mortgage affects one's credit score through inquiries and higher debt levels. These factors can lower scores temporarily. Missed payments on a second mortgage have long-term effects on credit health.
Paying off a second mortgage is sometimes considered a “rate-and-term” mortgage refinance rather than a cash-out refi. This can be an advantageous repayment option, since rate-and-term refis come with lower rates and fewer restrictions. Shop rates for your cash-out refinance.
If you can't make your second mortgage payments, the lender might foreclose or sue you.
If you pay $100 extra each month towards principal, you can cut your loan term by more than 4.5 years and reduce the interest paid by more than $26,500. If you pay $200 extra a month towards principal, you can cut your loan term by more than 8 years and reduce the interest paid by more than $44,000.
The 28% mortgage rule states that you should spend 28% or less of your monthly gross income on your mortgage payment (including principal, interest, taxes and insurance). To gauge how much you can afford using this rule, multiply your monthly gross income by 28%.
Lien stripping can convert your second mortgage from secured debt into unsecured debt, which often gets paid back at a lower rate or even discharged entirely. This relief can provide the breathing room needed to manage your finances better and avoid the threat of foreclosure.
The loan must be paid off first before the borrower can take on another mortgage against their home equity. Using a mortgage calculator is a good resource to budget these costs.
More Liquidity
Using your extra funds to pay off your mortgage reduces the amount of money you have for other expenditures. For example, you may need to build an emergency fund, pay off other high-interest debt, or buy a new car.
A good way to remember the documentation you'll need is to remember the 2-2-2 rule: 2 years of W-2s. 2 years of tax returns (federal and state) Your two most recent pay stubs.
Con: Special Attention and Maintenance
As the owner, you will either need to pay for a landlord to take care of your house, or you will need to roll up your sleeves and do it yourself.
While a second mortgage may seem like the only option to pay down your high-interest debts or fund an important renovation project, it's not always the best financial decision. If you have a large amount of equity or a good credit score, there might be more affordable alternatives available.
HELOC payment examples
For example, payments on a $100,000 HELOC with a 6% annual percentage rate (APR) may cost around $500 a month during a 10-year draw period when only interest payments are required. That jumps to approximately $1,110 a month when the 10-year repayment period begins.
While home loan interest rates overall have risen dramatically since 2022, HELOC rates still tend to be lower than those on credit cards and personal loans. If you qualify for the best rates, a HELOC can be a less expensive way to consolidate debt or finance a home renovation.
In many cases, lenders will set a minimum 620 credit score to qualify you for a home equity loan — though the limit can be as high as 660 or 680 in some cases. Still, there are some options for a home equity loan with bad credit.