Home Equity Loans and Mortgages: The Differences
Mortgages and home equity loans are both large loans that use a home as collateral, or backing, for the debt. This means that the lender can seize the home if you don’t keep up with your repayments. However, home equity loans and mortgages are used for different purposes and at different stages of the home buying and homeownership process.
Key Takeaways
- Mortgages and home equity loans are both large loans that use property collateral.
- With a home equity loan, the borrower takes out a loan when they already own the home and have equity.
- A home equity loan can be used for a variety of purposes, such as paying medical bills or funding a renovation.
- A traditional mortgage is used to buy a property.
- Home equity loans are fixed-rate loans, whereas a mortgage can be fixed rate or variable.
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Mortgages
A conventional mortgage is when a financial institution, such as a bank or credit union, lends money to you to purchase the property.
With many conventional mortgages, the bank lends as much as 80% of the home’s appraised value or the purchase price, whichever is less. For example, if a house is appraised at $200,000, the borrower would be eligible for a mortgage of as much as $160,000. The borrower would have to pay the remaining 20%, or $40,000, as a down payment.
In other cases, such as with government-backed loan programs that provide down payment assistance, you may get a loan for more than 80% of the appraised value.
Unconventional mortgage options include Federal Housing Administration (FHA) mortgages, which allow you to put as little as 3.5% down as long as you pay mortgage insurance. U.S. Department of Veterans Affairs (VA) loans and U.S. Department of Agriculture (USDA), require a 0% down payment.
The interest rate on a mortgage can be fixed (the same throughout the term of the mortgage) or variable (changing every year, for example).You repay the amount of the loan plus interest over a fixed term. The most common terms for mortgages are 15, 20, or 30 years, although there are other terms.
Before getting a mortgage, it's important to shop the best mortgage lenders to determine which one will give you the best rate and loan terms. A mortgage calculator is also great at showing how different interest rates and loan terms affect your monthly payment.
If you fall behind on payments, the lender can seize your home through foreclosure. The lender then sells the home, often at an auction, to recoup its money. Should this happen, this mortgage (known as the “first” mortgage) takes priority over subsequent loans made against the property, such as a home equity loan(sometimes known as a “second” mortgage) or home equity lineof credit (HELOC). The original lender must be paid off in full before subsequent lenders receive any proceeds from a foreclosure sale.
Home Equity Loans
A home equity loan is also a type of mortgage. However, you take out a home equity loan when you already own the property and you have accumulated equity. Lenders generally limit the amount of a home equity loan to no more than 80% of the total value of your equity.
As the name implies, a home equity loan is secured—that is, guaranteed—by a homeowner’s equity in the property, which is the difference between the property’s value and the existing mortgage balance. For example, if you owe $150,000 on a home valued at $250,000, you have $100,000 in equity. Assuming that your credit is good, and that you otherwise qualify, you can likely take out an additional loan using a part of that $100,000 equity as collateral.
Like a traditional mortgage, a home equity loan is an installment loan repaid over a fixed term. Different lenders have different standards as to what percentage of a home’s equity they are willing to lend. Your credit rating helps to inform this decision.
Lenders use the loan-to-value (LTV) ratio to determine how much money you can borrow. The LTV ratio is calculated by dividing the loan by the appraised value of the house. If you paid down a good deal of their mortgage—or if the home’s value has risen significantly, your loan-to-value ratio would be higher and you could likely get a larger home equity loan.
Note
Home equity loans are generally offered with a fixed rate, while traditional mortgages can have a fixed interest rate or variable interest rate.
Second Mortgages
In many cases, a home equity loan is considered a second mortgage. If you already have an existing mortgage on the residence. If your home goes into foreclosure, the lender holding the home equity loan does not get paid until the first mortgage lender is paid.
So, the home equity loan lender’s risk is greater, which is why these loans typically carry higher interest rates than traditional mortgages.
However, not all home equity loans are second mortgages. If you fully own your property, you may decide to take out a loan against the home’s value. In this case, the lender making the home equity loan is considered a first lienholder. An appraisal might be the only requirement to complete the transaction if you own the home outright.
Note
Home equity loans often have higher interest rates but lower closing costs than traditional mortgages.
Tax Deductions for Mortgages and Home Equity Loans
Home equity loans and mortgages can have similar tax deductions with their interest payments as a result of the Tax Cuts and Jobs Act of 2017. Before the Tax Cuts and Jobs Act, you could deduct only up to $100,000 of the debt on a home equity loan.
Now, interest on a mortgage is tax deductible for mortgages of up to either $1 million (if you took out the loan before Dec. 15, 2017) or $750,000 (if you took it out after that date). This new limit applies to some home equity loans as well if they were used to buy, build, or improve the home.
Homeowners can use a home equity loan for any purpose. But if you use a loan used for any other purpose other than buying, building or improving a home (such as to reorganize debt or pay for your child's college), you cannot deduct the interest.
Is a Home Equity Loan a Second Mortgage?
A home equity loan is a type of second mortgage that allows you to borrow money against the equity that you have in your home. You receive that money as a lump sum. It’s also called a second mortgage because you have another loan payment to make in addition to your primary mortgage.
What’s the Difference Between a Home Equity Loan and a Home Equity Line of Credit (HELOC)?
There are multiple key differences between a home equity loan and a HELOC. A home equity loan is a fixed, one-time lump sum that repaid over time. A HELOC is a revolving line of credit using a home as collateral that can be used and paid off over and over again, similar to a credit card.
Does a Mortgage or a Home Equity Loan Have Lower Interest Rates?
A mortgage will usually have a lower interest rate than a home equity loan or a HELOC. A first mortgage holds the first priority on repayment in the event of a default and is a lower risk to the lender than a home equity loan or a HELOC. However, a home equity loan will likely have lower closing costs.
The Bottom Line
If you have an extremely low interest rate on your existing mortgage, you probably should use a home equity loan to borrow the additional funds that you need. But there are limits on its tax deductibility, which include using the money for the purposes of improving your property.
If mortgage rates have dropped substantially since you took out your existing mortgage—or if you need the money for purposes unrelated to your home—you may benefit from a mortgage refinance. If you refinance,you can save on the additional money that you borrow, as traditional mortgages generally carry lower interest rates than home equity loans, and you may be able to secure a lower rate on the balance that you already owe.
Consider consulting a professional financial advisor who can guide you through the best options for your situation.
Certainly! Mortgages and home equity loans are substantial financial instruments secured by your property, offering different functionalities at varying stages of homeownership. I can elaborate on each concept mentioned in the article.
Mortgages:
- Conventional Mortgages: These loans, offered by financial institutions like banks or credit unions, finance property purchases. They typically cover up to 80% of a home's appraised value or purchase price.
- Down Payments: Usually, borrowers cover the remaining percentage as a down payment. Government-backed loan programs may allow loans exceeding 80% of the appraised value.
- Types: Mortgages can be conventional, FHA (requiring lower down payments), VA loans (for veterans), or USDA loans (for rural properties).
- Interest Rates: They can be fixed or variable, repaid with interest over specified terms (15, 20, or 30 years).
- Foreclosure: Falling behind on payments can lead to foreclosure, with the property sold to recover the lender's money.
Home Equity Loans:
- Definition: These loans are acquired when homeowners already possess the property and have accrued equity.
- Equity Calculation: Lenders limit home equity loans to around 80% of the total equity in the property, calculated as the property's value minus the existing mortgage balance.
- Secured Loans: Similar to mortgages, home equity loans are installment loans repaid over a fixed term and secured by the homeowner's equity.
- Loan-to-Value Ratio (LTV): Lenders use this ratio to determine the amount borrowers can access, which is calculated by dividing the loan by the property's appraised value.
- Interest Rates: Home equity loans typically have fixed interest rates and might carry higher rates than traditional mortgages due to the increased risk for lenders.
Second Mortgages:
- Home Equity Loan as a Second Mortgage: In many cases, a home equity loan is considered a second mortgage if there's an existing primary mortgage. In foreclosure, the first mortgage lender gets priority in repayment.
- Interest Rates and Costs: Second mortgages, like home equity loans, often have higher interest rates but lower closing costs compared to traditional mortgages.
Tax Deductions:
- Changes Post Tax Cuts and Jobs Act: Interest deductions for mortgages and some home equity loans were affected by this act. Limits and deductibility depend on the loan purpose and the timing of its acquisition.
- Eligibility for Deductions: Typically, interest on mortgages used for buying, building, or improving homes is tax-deductible.
Differences:
- Home Equity Loan vs. Home Equity Line of Credit (HELOC): The former offers a lump sum, while the latter operates as a revolving line of credit similar to a credit card.
Interest Rates and Closing Costs:
- Comparative Interest Rates: Mortgages generally carry lower interest rates compared to home equity loans or HELOCs due to their priority in repayment.
- Closing Costs: Home equity loans may have lower closing costs than traditional mortgages.
Choosing Between Options:
- Factors in Decision-Making: Deciding factors include existing mortgage rates, loan purposes, tax implications, and financial goals.
- Considerations for Refinancing: Refinancing existing mortgages might be beneficial if rates have substantially decreased or if funds are needed for purposes unrelated to the home.
Professional Advice:
- Consulting a Financial Advisor: Seeking guidance from a financial advisor can help navigate through these options and determine the best approach for individual situations.
Understanding these nuances can significantly impact financial decisions concerning property ownership and loan management.
