The difference between a first and second mortgage
For many, a home loan is what transforms property ownership aspirations to a place they call home. But as far as that loan goes, a common question is, “What is a first-position mortgage?”
If you, like many aspiring homeowners, find mortgages a complex topic, you may not even realize having more than one—on the same property—is possible.
So here's an explanation of what first and second mortgages are, how they differ, and how to use them.
What is a first mortgage?
When someone buys a house, they usually can’t afford to pay cash for it in a single lump sum. Instead, they secure a loan from a bank or another lender to cover the expense, commonly called a first mortgage.
In return, they promise to make monthly payments to the lender over a period of years, usually 15-30.
These monthly payments include the amount borrowed (the principal) and the fee the bank charges for lending them the money (interest).
What is a second mortgage?
If you have substantial equity in your home, 20% - 25% or more, you can obtain a second loan that uses that equity as collateral.
(Equity is the difference between what your home is worth in the current market and the amount you owe on your first mortgage.)
Funds from the second loan, or mortgage can be used for anything you like.
Due to their high-risk profile, second mortgages have higher interest rates than first mortgages. The two most prevalent types are home equity loans and home equity lines of credit (HELOCs).
- Home equity loan: A lump sum of money based on your home equity, which you repay monthly at a fixed interest rate.
- HELOC: A revolving line of credit based on your home equity, where you only pay for the amount you borrow at a variable interest rate.
Reasons for getting a second mortgage
While the best reason for getting a second mortgage is to finance home improvement projects that boost your property’s market value, there are others:
- Favorable loan terms: Sometimes, a second mortgage can increase your down payment, leading to a lower interest rate on your first mortgage and help you to avoid private mortgage insurance (PMI)
- Invest in a second property: People often leverage the equity they've built in their existing home to acquire a second property
- Debt consolidation: You can use a second mortgage to pay off high-interest debts, such as credit card balances, personal loans, student loans, or medical bills
- Start a business: Bank business loans have high-interest rates ranging from 6%-17% and upward. The average rate on a 30-year second home mortgage is often cheaper, around 7.12%
- Make a big purchase: Though not as common, people sometimes take out a second mortgage to buy a new vehicle or lifestyle goods they need but can't afford
- Pad your retirement fund or savings to have cash on hand in case of an emergency
Requirements for a first and second mortgage
The essential prerequisites and considerations between a first and second mortgage:
| Requirement | First mortgage | Second mortgage |
| Credit score | Minimum 620 | Minimum 640 |
| DTI (debt-to-income ratio) | 36% or less | 43% or less |
| Down payment | Ideally 10% - 20%, but its possible to get a mortgages with down payments as little as 3.5%. | 10 - 20% |
| Assets | Some reserves may required to cover the first few months of repayments | May not require significant reserves but assets can strengthen your application |
| Income stability | Stable and verifiable | Stable and verifiable |
| Employment history | Consistent employment history of 2 years or more | Consistent employment history of 2 years or more |
| Loan term | 15 - 30 years | 5 - 20 years |
| Interest rate | Lower interest rate | Higher interest rate |
How first and second mortgages work
Imagine you bought a home for $200,000 and put 10% or $20,000 down, so your initial (first) mortgage amount was $180,000 payable over 30 years.
Over a period of ten years, you diligently paid down $100,000 toward your principal, reducing the balance on your first mortgage to $80,000 and giving you 50% equity in your home.
You decide to renovate your bathroom and kitchen by taking out a second mortgage for $50,000 to cover the costs.
Here's the breakdown of your mortgages:
- Your first mortgage, with its interest rate of 4% was for 30 years and the payments are approximately $859 a month.
- Your second mortgage, which you took out for the renovations, carries an interest rate of 6% and a 10-year term, so the monthly payments are about $555.
When you combine both mortgage payments, you'll pay approximately $1414 a month. You'll continue to pay this much per month for ten years, until you've paid off your second mortgage.
After that, you'll still have another ten years to fully pay off the first mortgage, assuming you stick to the regular payment schedule without increasing your payments to expedite the process. But for those ten years, you'll be back to paying $859 a month.
What if you default on your mortgages?
Here’s what happens if you can't make payments on your second mortgage based on the previous example:
- Default and foreclosure: If you begin to miss payments on your second mortgage, the lender may start foreclosure proceedings. They'll sell your property to recoup the outstanding second mortgage debt.
- Payment hierarchy: Your primary mortgage lender is first in line to be paid. You sell the property for $200,000. $80,000 goes to the first mortgage holder leaving you with $120,000 left from the property sale.
- Second mortgage repayment: The lender who initiated the foreclosure, the second mortgage lender, gets paid next. Your second mortgage amount was $50,000. You are left with $70,000.
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Possible deficiency: If your house sells for less than the original purchase price and the amount you receive from the sale only pays off the first mortgage but doesn't cover the entire second mortgage you will still owe the second lender the difference. If that happens, the second mortgage lender might sue you for the remaining balance on that loan.
How to find the best mortgage
As with all loans, you should only take out a mortgage if you can comfortably afford to pay it back. Getting pre-approved before you start shopping for a house will give you an idea of how much you can borrow.
If you require assistance, consider enlisting the services of a mortgage broker. They specialize in connecting you with a lender that suits your requirements, all for a flat fee and a commission based on the deal they secure.