Taking out a second mortgage sounds terrifying.
When most of us think back to the long process of buying a home the first time, it’s hard to imagine why someone would want to do that again.
In reality, though, there are a number of reasons to take out a second mortgage:
- To pay for college tuition.
- To cover a major expense.
- To make improvements to your property.
The list goes on.
Simply put: it’s a really big lump sum of cash that can come in handy.
When it comes to getting one – it’s going to be as arduous as the first time you got a mortgage. Don’t worry, though, at least you’ve already been through the process once!
What’s Ahead:
Start by weighing the risks of a second mortgage
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As you consider the option to take out a second mortgage on a rental property, consider these very real risks:
- You will increase your debt. When you take out another mortgage on the property, you will increase your outstanding liabilities. The result is that you’ll likely experience an increase in financial stress.
- A second mortgage gives a lender the right to repossess your property if you can’t repay the loan. If you are in doubt about your ability to repay the loan, then you may want to look for another way to access funds. For example, an unsecured personal loan could provide the funds you need without the threat of losing a rental property.
Read more: Unsecured Vs. Secured Loans: What’s The Difference?
Consider what type of second mortgage you want
The right second mortgage for you will depend on the reason why you need the funds.
Home Equity Line Of Credit (HELOC)
The first is a HELOC, or a home equity line of credit. Essentially, you can think of a HELOC as a line of credit that is secured by the equity you’ve built in a rental property. Depending on the amount of equity you’ve built, you may be able to tap into a significant credit line.
When you take out a HELOC, you’ll be able to borrow the funds you need when you need them. Depending on your lender, you may receive specialized checks or a credit card to use for purchases. With this setup, you won’t run the risk of overborrowing. Plus, the flexibility of having access to funds quickly is a perk that cannot be overstated.
Additionally, a HELOC is a revolving line of credit which means that you can repay the funds you borrow and then proceed to borrow the funds again.
For example, let’s say that you are approved for a HELOC of $15,000. But you only choose to spend $10,000 and repay it quickly. Once you repay the borrowed funds, you’ll be able to borrow up to $15,000 again from the same HELOC.
Read more: Need A Loan? If You’re A Homeowner Here’s Why You Should Consider A HELOC
Home equity loans
The second option is a home equity loan. When you obtain this type of loan, the lender will disburse the funds all at once and you will pay down your loan similarly to a traditional mortgage.
With a home equity loan, you can’t withdraw more funds along the way. Instead, you’ll just steadily pay down the balance.
The right option for you will depend on the reason why you need the funds and consider whether or not you’ll need long-term access to funds.
Read more: Home Equity Reality Check: Everything You Need To Know Before Taking Out A Home Equity Loan
Shop around for the right lender
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Once you decide on your preferred mortgage type, it’s time to shop around for the right lender. You’ll have a couple of options to choose from at this point.
Direct lenders
A direct lender is a bank or credit union that offers mortgages directly to borrowers. There’s no middle man involved in this process, so there won’t be any rate comparison involved. The terms they give you are the terms they give you.
You’ll need to fill out a full application (or take advantage of prequalification options) to get a sense of your rates from each individual lender, which can be time-consuming.
To learn the full process of finding the best direct lender for you, check out our article: How To Find The Best Online Mortgage Lenders.
Mortgage brokers
That middle man I was talking about – that’s a mortgage broker.
They’re an independent entity that’s not tied to a specific mortgage company. They can help you match with the right lender…for a price. Typically the borrower will pay a small percentage of the loan amount (1%-2% is the average).
You can learn if this is the right option for you in our article: Should You Use A Mortgage Broker Or A Bank Loan Officer?
Comparison platforms
Comparison sites let you…well, compare your potential rates for multiple different companies all in one place. Plus, your credit score isn’t pulled, so you won’t see a ding on your report.
It’s definitely worth giving comparison shopping sites like Credible a chance. Even if you don’t find the right fit, then you’ll at least find some baseline numbers to start your search.
Finding the right lender is the biggest hurdle. Once you find a lender willing to work with you on fair terms, it is time to dive into the paperwork.
Unfortunately, the lender will likely have a lengthy paperwork process. It will remind you of your original mortgage closing (yikes). And with that, you’ll need to provide much of the same information.
Read more: What Should You Expect When Closing On A House
Pros & cons of taking out a second loan on a rental property
Pros:
- Freedom to use funds as you wish. Unlike a traditional mortgage, you can spend the proceeds from a second loan however you wish. You might use the funds to cover the down payment of another property for your portfolio or cover a more personal expense such as a wedding or eliminating credit card debt.
- The second loan is not attached to your primary residence. Anytime you take out a second loan, you run the risk of defaulting on that loan. Of course, no one takes out a second loan on a property with the intention of defaulting. But if you run into an economic hardship that forces you to default on this second loan, the silver lining is that you won’t lose your personal home.
- Potential for high loan amounts. Depending on the amount of equity you’ve built in a property, you may have access to a substantial loan amount. The rules vary based on the lender, but you might be able to take out as much as 90% of your property’s value as a second mortgage.
Cons:
- Higher interest rates. A second loan on a rental property will come with a higher interest rate than your primary loan. That’s because lenders are taking on more risk when they finance a second mortgage (if you file for bankruptcy – your first mortgage gets paid off first with any collateral you have).
- An increased debt burden. The downside of taking on more debt is obvious, but it is critical to consider. When you take out more debt, you are putting a crunch on your monthly budget. Make sure that you can afford the monthly repayments before signing on the dotted line.
- You’ll need a good credit score to secure the best rates. Some experts estimate that you’ll need a credit score of at least 620 to obtain this kind of loan. That means those with poor credit will likely need to find financing elsewhere – or settle for outrageously high interest rates.
- You can only deduct interest payments on your taxes under certain circumstances. You must use your HELOC or home equity loan for home improvements or other business expenses related to your rental if you’d like to deduct any interest when you go to do your taxes. So, if you use a HELOC to pay for your kid’s braces, you can’t claim any deductions on the interest you pay.
What are some alternatives to a second loan on a rental property?
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If you’re not willing to take on the risks necessary to obtain a second mortgage on your rental property, there are still a few other ways to cover the expenses you face.
Here are a few good options:
- Cash-out refinance. If you have considerable equity built in your property, then a cash-out refinance could give you the cash you need without taking out a second mortgage. Instead, you would replace your existing mortgage on the rental property with a new one.
- Personal loan. Regardless of the amount of equity you’ve built in your rental property, an unsecured personal loan could provide the cash you need. The best part is that you won’t have to put any assets on the line.
- Credit cards. Of course, turning to a high-interest credit card could lead to more problems than you solve. But if you need quick access to funds, this could help you solve an immediate financial issue.
Take some time to weigh your options. As you move forward, the consequences of any loan will make an impact on the future of your finances.
Summary
Investing in real estate is a useful way to build wealth. Beyond that, your portfolio could provide access to cash in the form of a second mortgage along the way.
But getting a second mortgage isn’t a process to enter into hastily (remember the first time you did it?).
While you’ll have tow solid choices: HELOCs and home equity loans, these loans come with higher interest rates and you’ll need a good credit score to even qualify.
Make sure you consider these points before diving in.
Curious about investing in real estate? Learn more about this wealth-building strategy today.
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