If you have a home improvement project you want to complete and you need a way to cover the cost, you might be looking to tap into your home equity to make your project a reality. You’re possibly wondering if you should look into a home equity loan or a mortgage. What’s the difference? We’ll explain everything you need to know in this guide.
Key Takeaways:
- A mortgage is a secured loan that helps you finance a home purchase.
- A home equity loan is a second mortgage separate from your primary mortgage, which can allow you to tap into your home equity to receive a lump-sum cash payout.
- If you need to borrow money for expenses, like home improvements or debt consolidation, home equity loans are a good option because they typically have much lower interest rates than unsecured lending solutions, like personal loans.
How A Mortgage Works
A mortgage is a loan that uses your home as collateral. A lender places a lien on your property in exchange for giving you the loan. The lien gives the lender the right to take ownership of the home if you can’t make the monthly payments. However, the mortgage process is designed to qualify you so that the lender feels confident you can afford a house payment.
There are many types of mortgages. The most common mortgages are conventional loans from Fannie Mae or Freddie Mac and FHA and VA loans. There are also primary and second mortgages, which we’ll explain in detail later.
The requirements to qualify for a mortgage vary based on the standards of your lender and organization backing the mortgage, such as the FHA or the VA.
Generally, lenders will evaluate your income, assets and credit history to determine your eligibility for a home loan. The higher your credit score and down payment or amount of existing equity, the better you can expect your interest rate to be.
Other factors impacting your interest rate include how the property is occupied (primary residence, vacation property or rental home) and whether it’s a primary or second mortgage.
Is A Home Equity Loan A Mortgage?
A home equity loan is a type of mortgage, also known as a second mortgage. It’s a separate mortgage that a homeowner can take out in addition to the primary home loan used to purchase or refinance their home. It is usually taken out at a different time from when you would get a primary mortgage.
If you get a home equity loan, it won’t be bundled into your primary mortgage payment. Instead, it’s an additional mortgage with its own terms and monthly payment.
A second mortgage is subordinate to your primary mortgage, meaning if you default on your payments and the lender sells your property to help recoup their expenses, the primary mortgage holder gets paid first. Because of this, rates on second mortgages are higher than the available rates for primary mortgages.
Second mortgages can be advantageous: If you have a low rate on your existing mortgage and don’t want to touch it to access some of your equity, a second mortgage allows you to do this.
Your lender can help you with something called a “blended rate calculation” to determine whether a cash-out refinance or second mortgage is right for you.
What’s Your Goal?
Buy A Home
Discover mortgage options that fit your unique financial needs.
Refinance
Refinance your mortgage to have more money for what matters.
Tap Into Equity
Use your home’s equity and unlock cash to achieve your goals.
How A Home Equity Loan Works
Homeowners who have equity built up in their property can take out a home equity loan. The funds from a home equity loan are distributed as a lump-sum payment, meaning you get the full amount borrowed at one time. If you know how much you need to borrow, a home equity loan can be a great option.
Most home equity loans have fixed interest rates. A home equity loan works like a primary mortgage in the sense that you will have a monthly payment until the end of the loan term. But you’ll have two separate mortgage payments.
Home Equity Loans Vs. Home Equity Lines Of Credit (HELOCs)
When considering a second mortgage, homeowners actually have two options: a home equity loan and a home equity line of credit (HELOC). From a funding perspective, a home equity loan works like a cash-out refinance. You receive a check for the amount of equity you take out.
But HELOCs function differently. A HELOC has two distinct phases: a draw period and a repayment period. During the draw period, you can withdraw as much or as little of your equity as you want (up to your limits) through a revolving line of credit that works like a credit card.
During the draw period, you only make interest payments on any amount you withdraw. You can also put money back into the HELOC during the draw period to access it later.
Once the draw period ends, the repayment period begins. The balance freezes, and you can’t borrow against the line of credit anymore. For the remainder of the term, you make monthly payments toward the principal and interest until the HELOC is paid off.
Another difference is that while most home equity loans have fixed interest rates, HELOCs typically have variable interest rates like credit cards, meaning the rate can change month to month. If it’s not variable, it may also be adjustable, meaning the rate changes at some point.
Get a Home Equity Loan online
Let’s match you up with lenders who can help with your unique financial situation.
Home Equity Loan Vs. Mortgage
In this section, we’ll compare some features of home equity loans and mortgages. Exact policies vary by lender.
| Home Equity Loan | Primary Mortgage |
|---|---|---|
Collateral | Yes, backed by the property | Yes, backed by the property |
| Lien Position | Second | First |
| Interest Rate | Higher | Lower |
Loan Terms | Varies; generally 15, 20 or 30 years | Varies; generally 15, 20 or 30 years |
Maximum Loan Amount | Varies based on your home’s value minus your mortgage balance | Highly variable based on the loan type and location and the number of units; the baseline nationwide conforming loan limit is $806,500 |
Closing Costs | Varies; usually 2% – 5% of the loan amount | Usually 2% – 5% of the home purchase price |
Tax-Deductible Limits | If you itemize, you can deduct mortgage interest on up to $750,000, but only if the home equity loan is used to buy, build or substantially improve your home. | If you itemize, you can deduct mortgage interest up to $750,000. |
When To Consider A Second Mortgage Vs. A Refinance
Homeowners first obtain a mortgage when they need to borrow money to purchase a house. But you have options when you wish to borrow against your home equity to finance a home improvement project or consolidate debt. You might choose to take out a second mortgage, such as a home equity loan, or you might prefer to refinance your existing mortgage.
Need help comparing a second mortgage with a refinance to determine if a home equity loan or cash-out refinance is the best solution? The first thing to know is that interest rates will always be lower for primary mortgages than home equity loans because home equity loans are second mortgages.
Determining which option is best for you is not as simple as comparing the interest rates for the refinance with those of a home equity loan. That’s because if the interest rate for your primary mortgage is low enough, you might save money on interest by not touching it and taking out a home equity loan, even if the interest rate on the loan is higher than the refinance rate.
When To Consider A Mortgage Refinance
A blended rate calculation can help you determine the best loan option. Blended rate is the weighted average interest rate of your primary mortgage and a hypothetical home equity loan.
If the average is higher than what you can get by taking out a cash-out refinance, you’ll likely want to refinance your primary mortgage. Meanwhile, a home equity loan is a better solution if the blended rate is lower than the cash-out refinance rate.
To calculate the blended rate, you’ll need the following numbers:
- Interest rate of primary mortgage
- Remaining mortgage balance
- How much equity you plan to take out
- Interest rate of the proposed home equity loan
Here’s an example:
Your home is worth $400,000, and your outstanding mortgage balance is $200,000. You want to take out $100,000 worth of equity. Your primary mortgage rate is 3.25% and you have 20 years left on the term. The rate for a 20-year home equity loan in this hypothetical is 13%. To get a 20-year cash-out refinance, the rate would be 6.375%.
Here’s how to calculate the blended rate:
(Primary mortgage balance × interest rate) + (home equity loan amount × interest rate)
_______________________________________________________
Primary mortgage balance + home equity loan amount
Using the above scenario, the blended rate is 6.5%. Because this is higher than the cash-out refinance rate of 6.375%, it makes more sense to do a cash-out refinance.
When To Consider A Home Equity Loan
To determine if a home equity loan is a better solution, we’ll use the same equation and many of the same numbers from above. The only number that will change is the proposed home equity loan rate, which is now 10.25%. In this scenario, the blended rate becomes 5.583%.
Since the blended rate is lower than the hypothetical cash-out refinance rate of 6.375%, it makes sense to get a home equity loan rather than change the rate on your current mortgage.
FAQ
Here are some answers to commonly asked questions about a home equity loan vs. a mortgage:
The Bottom Line: A Home Equity Loan Is A Second Mortgage
A home equity loan is a type of mortgage that’s secondary to your primary mortgage. It’s similar to a cash-out refinance in that you get a lump-sum payment for whatever equity you take out. Keep in mind that missing payments on either your primary mortgage or home equity loan could put your home at risk of foreclosure.
If you’re considering a home equity loan, a HELOC is an alternative to explore. The difference is that it’s a line of credit at the beginning of the term, allowing you to use the funds as needed before the balance freezes in the latter half of the term.
Whether a cash-out refinance or a second mortgage, like a home equity loan, is right for you depends entirely on the blended rate. A lender can help you better explore your options.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
