What is a second mortgage?
A second mortgage lets you tap into your home equity by borrowing against the value you’ve built up in your property. Equity is the difference between your home’s current value and the balance remaining on your home loan.
This type of loan is considered an encumbrance – an additional interest registered on your property title, alongside your original mortgage. It doesn’t replace or alter your existing home loan, and it doesn’t have to be with the same lender.
However, you’ll usually need permission from your initial lender to register a second mortgage on the property title.
The reason for the second mortgage is key
Mansour Soltani, Money.com.au's Home Loans Expert
“If the lender does not like the reason you want to take the second mortgage, and/or it does not fit their policy, then it doesn’t matter if they are the first mortgagee or not, it will be rejected.”
Mansour Soltani, Money.com.au's Home Loans Expert
How does a second mortgage work?
When you take out a second mortgage, you essentially have two different loan amounts secured against your property. The second mortgage is ‘subordinated’ to the first mortgage. This means that in the event of a loan default, the lender that issued the first mortgage gets repaid first, before any money is paid to the second mortgage lender.
To get a second mortgage loan, you’ll need to have enough usable equity in your property – equity you can borrow against (as opposed to a cash deposit for your first mortgage).
Otherwise, a second mortgage works like a standard mortgage. You’ll borrow a lump sum from a lender, which you’ll repay with interest over a fixed term through regular repayments. It will be a debt alongside your first home loan.
Features of a second mortgage
- Home loan interest rates on second mortgages are generally higher than first mortgages, as they are considered riskier for lenders (i.e. the second mortgagee gets paid last if there’s a default).
- Because you’re using equity as security for the loan, your second mortgage will usually have a lower loan-to-value ratio (LVR) than your initial mortgage. Generally, the combined first and second mortgage cannot exceed an 80% LVR. That’s both loan amounts relative to the property’s value.
- Second mortgages are usually for smaller amounts and have shorter repayment terms (ranging from 10-20 years).
- Stricter eligibility requirements than first mortgages, which means not all lenders offer this type of product.
- Typically offers similar features to those of a standard loan, such as an offset account, options for additional repayments, and a redraw facility.
How much could you borrow for a second mortgage?
Most lenders require you to maintain 20% equity in your home after taking out your second mortgage. Therefore, if you have 50% equity, you can borrow up to 30%, so that 20% equity will remain in the property.
Suppose your home is valued at $800,000, and your existing first mortgage balance is $400,000. Given the lender's maximum LVR of 80%, the calculation would look like this:
- Calculate the total value you can borrow up to 80% LVR Maximum total loan amount = property value × 80% Maximum total loan amount = $800,000 × 0.80 = $640,000
- Calculate the current loan balance Current loan balance = $400,000
- Calculate the maximum second mortgage loan amount Maximum total loan amount = $640,000 − $400,000 (current loan balance) Maximum second mortgage loan amount = $240,000
Therefore, you could borrow up to $240,000 with the second mortgage to maintain a combined LVR of 80%.
Four ways you can use a second mortgage
Here are some scenarios when taking out a second mortgage could make sense:
When acting as a guarantor
If you’re acting as a guarantor on a mortgage for your children or other family members, some lenders – such as Bankwest and Commonwealth Bank – offer guarantor loans structured as two separate home loans. One is secured by the property being purchased, and the other is secured by a portion of your equity (typically just enough to reduce the loan-to-value ratio to 80%).
If you need an alternative to refinancing
There may be instances where refinancing your current loan doesn’t make financial sense. For instance, if you're locked into a fixed-rate loan and face high break costs, you might choose a second mortgage instead. Similarly, if you’re on a competitive fixed rate, you may opt for a second mortgage to maintain that rate.
To free up funds to buy an investment property
Some borrowers may take out a second mortgage to leverage their equity and buy an investment property or second home. There are some risks involved with this. If your property's value falls below the outstanding balance of both loans, this would put you in negative equity. This means you couldn't fully repay both mortgages by selling the property if it goes into default.
To free up cash flow for other expenses
You can take out a second mortgage to access additional funds for various purposes like home renovations, debt consolidation, pay off tax or student debts, or as a caveat loan (a business loan secured partially by home equity), for example. A second mortgage may have lower interest rates than a personal loan or credit card.
Pros and cons of a second mortgage
Pros
- Allows you to leverage some of your home equity without selling the property
- You don’t have to change the terms of the first mortgage, which is ideal if you're already on a competitive rate
- May be cheaper than refinancing if you’re locked into a fixed loan term with high break costs
Cons
- Usually comes with higher interest rates and may involve extra fees for lender assessment and changes to the property title
- Increases your debt and means managing two separate mortgage repayments
- Stricter eligibility applies, as lenders must assess your capacity to repay both loans
How to apply for a second mortgage
Only a few lenders offer second mortgage products and those that go generally have strict lending criteria due to the reduced security position compared to a first mortgage.
There are two ways you could apply for a second mortgage:
1. Directly with a specialist lender
These are generally smaller lenders that offer alternative mortgages and non-conforming loans (e.g. low doc home loans, bad credit home loans). Keep in mind that specialist lenders tend to charge higher interest rates and risk fees. If you apply through a specialist lender directly, you’ll need to send all your income and property documents yourself. You may have to call a few lenders to ask if they offer second mortgage products.
2. Through a mortgage broker
A broker will typically have access to a panel of lenders that offer second mortgages. They will conduct a borrowing assessment based on the information you provide to suggest potential second mortgage products for your situation. A mortgage broker will generally handle the entire application process on your behalf from start to finish.
In either case, you’ll be asked to submit some supporting documents including:
- Proof of income, including two payslips for the year to date or two latest tax returns if you’re self-employed
- Records of living expenses, assets and liabilities
- Your current home loan statements
- A copy of your property title
The lender will need approval from the first mortgagee to register a second mortgage on the property title, and you may get pre-approval subject to this decision. The lender will need to confirm the maximum they can claim against the property in the event of default before a second mortgage can be added. Your new lender will conduct their own property valuation before granting unconditional approval.
Your lender may refuse a second mortgagee (lender) on the property to mitigate their risk. They may not want another party to have an interest over the secured property. One possible way around that is to get your second mortgage from the same lender as your first.
Second mortgage vs cash-out refinance: What’s the difference?
Second mortgage
- A second mortgage is a loan you get on top of your original mortgage. This means you have two separate loans with different interest rates and terms.
- You’ll make two mortgage repayments each month/fortnight/week.
- Interest rates are typically higher than refinance rates because second mortgages pose a greater risk for lenders.
Cash-out refinance
- Access equity by topping up your current loan or refinancing with a new, larger loan that includes different terms.
- You end up with a larger, single loan – you’ll make one single (larger) repayment.
- Often cheaper than a second mortgage, since you only pay one set of home loan fees.
Not all lenders offer second mortgages
Mansour Soltani, Money.com.au's Home Loans Expert
“Those that do often charge higher interest rates and impose additional fees to mitigate risk. We generally recommend cashing out equity over getting a second mortgage. The process is much more commonplace as long as the reason is legitimate and acceptable. Each lender has policies around cashing out equity and cash out limits.”
Mansour Soltani, Money.com.au's Home Loans Expert
In most cases, a cash-out refinance is cheaper and simpler than taking out a second mortgage. It doesn’t require your current lender’s permission to register another loan, and you’ll only have one loan, one repayment, and one set of fees – making it easier to manage overall.
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