Most people know what a mortgage means and when you might need it. The mortgage loan is a type of borrowing with restricted use people obtain to buy a house. But do you know what a home equity loan is about? It may seem that these two are similar to each other, but there is a significant difference when you compare a home equity loan vs. mortgage.
Wonder which one you need to choose? So, let’s take a closer look.
Table of Contents
- What Is a Traditional Mortgage?
- What Is a Home Equity Loan?
- How Does a Home Equity Loan Work?
- Why Is a Home Equity Loan Called a Second Mortgage?
- What Is The Difference Between Home Equity Loan And Mortgage?
- What Is a Cash-Out Refinancing?
- Things to Consider Before Taking Out Home Equity Loans
- Bottom Line
What Is a Traditional Mortgage?
A mortgage is a lending option created to help people finance a home. Mortgages are typically offered by banks, credit unions, or some private mortgage lenders. You can also find a loan offered by the Federal Housing Administration or Veteran Home Affairs if you meet their specific requirements. Some lending services can also help customers with both home financing and choosing the equity they can afford.
To access a mortgage, you need to meet some specific requirements a mortgage lender sets up. Qualifications may vary from lender to lender, but here are some basic eligibilities you will be asked to fit:
- Have a good or excellent credit history – this mark shows your credit score, payment reliability, and overall creditworthiness;
- Have a low enough debt-to-income ratio – the lower the ratio, the more money you have left on hand after fulfilling all your existing loan payment obligations;
- Make a down payment – before applying for a mortgage, you need to set aside at least 5% of your house’s purchase price (may not be required if you apply for a VA loan or a USDA mortgage);
- Get ready to cover closing costs – they may reach nearly 3% of your entire loan amount.
Future homeowners usually prefer a 30-year mortgage at fixed interest rates. It helps them divide their loan cost by the longer repayment terms to make monthly payments affordable. Unlike a variable interest rate, a fixed interest rate means that your monthly payment will be predictable within the loan terms, regardless of the interest changes provided by big banks. However, you can also access a 15-year mortgage if your income is enough to cover higher monthly payments.
What Is a Home Equity Loan?
A home equity loan is a borrowing option that is available for those who already have a house. You may use it both when you still pay your mortgage loan and when you’ve already paid it off. If you still make your monthly mortgage payments, a home equity loan will be a sort of the second mortgage for you. The exact amount you can borrow generally depends on the appraised value of your home, credit score, payment history, and the particular lender.
A home equity loan is one lump sum payment you get in your bank account and can use for any current needs. However, keep in mind that you will be obliged to make both your monthly mortgage payment and home equity loan monthly payment. Thus, if you’re on your way to repaying a mortgage, you may face a financial burden you can’t bear.
How Does a Home Equity Loan Work?
Home equity loans enable you to get the loan amount you need against the equity you own. Put simply, you can borrow money by using the part of your equity in your home as collateral. Thus, you provide the lender with a pledge it can repossess in case of default.
Let’s look at an example. Suppose your house costs $400,000. If you’ve taken out $300,000 on your current mortgage, then you can use the remaining $100,000 of your home’s equity as collateral backing. Most lenders offer between 80% and 85% of your equity. It usually depends on your credit history, whether you apply for a consumer loan or have a single application, and whether your home is a principal residence or an investment property. Thus, your home equity loan amount may be from $80,000 to $85,000.
Also, there are home equity lines of credit, which are also called HELOCs. They offer a credit line you can access within a credit limit. So, these second mortgages work similarly to credit card cash advances. The benefit of a home equity line of credit is that you don’t need to make interest payments on the whole balance you’ve borrowed. Most lenders offer HELOCs with a draw period that allows you to only pay interest on what you’ve actually used.
The repayment period may range between 5 and 30 years for a home equity loan and 5 to 20 years for a HELOC. Thus, home equity loans tend to come with higher loan payments compared to mortgages. However, these are also fixed-rate loans with predictable monthly installments and lump sum funding. When the draw period ends, the repayment period begins.
Why Is a Home Equity Loan Called a Second Mortgage?
It doesn’t matter what your financial goal is. The main reason for calling a home equity loan a second mortgage is that you also use your home as a pledge. As people often obtain home equity loans in addition to their mortgage to make a home renovation or cover some huge expenses, a home equity loan is commonly a second load of debt you must repay. Thus, you have to pay one more long-term loan in addition to making monthly payments on your primary mortgage.
What Is The Difference Between Home Equity Loan And Mortgage?
So, let’s start with what they have in common. Both a mortgage and a home equity loan is secured debt that comes with the risk of losing your equity. They are also tax deductible for loan amounts up to $750,000. Both these loans have a flexible repayment schedule, typically with fixed monthly payments and interest rates. They are also equally intense in terms of the application process, as they often come with significant loan amounts. However, these two loans have some core differences.
A mortgage has restricted use. You can only spend the money you get to purchase a house, while home equity loans can be spent on any needs. You can consolidate debt or pay off your high-interest loan or credit card debt. Feel free to start your new business or pay tuition. There are no restrictions on purpose.
Also, a home equity loan doesn’t require any down payment and can be available for borrowers with less-than-ideal credit scores. At the same time, home equity loans require you to already have a home, while mortgages are a way to buy one.
What Is a Cash-Out Refinancing?
A cash-out refinance is another way to borrow money against your equity. It allows you to get a new mortgage that will replace your existing one. Moreover, this new loan will be bigger, so you will get one lump sum funding of the remaining balance in your bank account. Thus, you can both cover your primary mortgage and get an additional cash-out loan you can use as a personal loan.
A cash-out refinance also offers a fixed interest rate that is typically lower than the one on a second mortgage. Thus, a cash-out refinance considered a favorable option for people who get a mortgage at a higher interest rate.
At the same time, cash-out refinances provide higher amounts, so you need to calculate whether it will be beneficial for you before obtaining one. Also, as you’ve probably guessed, cash-out refinance is not available for those who have already paid off their mortgage loan.
Things to Consider Before Taking Out Home Equity Loans
Like any other loan option, a home equity loan requires you to consider at least several offers to make sure you choose the one with a better loan term. When it comes to a home equity loan, choosing the right lender is very important. Compare various loan providers that operate in your area. First of all, pay attention to an interest rate, repayment term, eligibility requirements, and the amount of your monthly payment.
Also, before you decide on a home equity loan, consider other available options. Maybe there is a better way you’ve overlooked to solve your financial problems. Check out personal loans if you need a smaller amount, or pick a car loan with no down payment if you’re looking for the funds to buy a vehicle.
As home equity loans have their drawbacks, it will be easier for you to make a lending decision when you know for sure when obtaining them may be a good idea. Thus, you can consider these loans in the following situations:
- You need a significant amount asap – a home equity loan is a good option when you need a lot of money for your personal needs but at a reasonable interest rate;
- You have a steady income and a good financial situation – as this is a dicey type of loan that may lead to losing your home in case of any financial problems with payments, you need to think twice before getting a loan to value the risk;
- You’re going to repay another debt at higher interest – refinancing your expensive debt may also be a good idea that can help you save money in the long run.
Also, if you’re looking for a loan with more flexibility, consider taking out a home equity line of credit that allows you to access the funds as needed within the set credit limit.
At first glance, when we compare a home equity loan vs. mortgage, it may seem that there is no big difference between them. However, it’s not true. Home equity loans work similarly to secured personal loans, while a mortgage is a home loan created to help you purchase a house you can’t afford without additional assistance.
As the interest rate on a home equity loan is usually fixed, the amount you owe each month will be predictable, too, so you can stick to your budget and manage finances with ease. This loan may be a good option for homeowners with stable incomes and those who need a large amount fast.
If home equity loans seem dicey for you, consider a cash-out refinance or an unsecured personal loan. You can also apply for a home equity line of credit if you’re looking for more flexibility.
Home Equity Loan vs. Mortgage – Which Have Lower Interest Rates and Monthly Payments?
Home equity loan interest rates are usually higher compared to mortgage interest rates. However, when it comes to a monthly payment, there is no simple answer, as everything depends on many factors. To say for sure, we need to take into consideration your loan term, credit score, closing costs, and the specific lender.
What Can I Spend a Home Equity Loan Amount for?
Actually, there are no restrictions on loan purposes. Unlike a mortgage, which you can only use to buy a house, this loan allows you to cover any expenses or needs you have, from education costs to medical bills.
Can I Apply for Home Equity Loans With Bad Credit?
As home equity loans are secured debt, lenders typically set up fewer requirements. Therefore, you can apply with a less-than-perfect credit score and get the money you need. However, a lender will check your credit report details through major credit bureaus, so it may temporarily lower your credit score.